And, another thing… Last month we discussed the many “interesting” topics making economic news, ranging from oil to Europe to China to the renewed push within the Federal Reserve to break up the “too big to fail” banks. For these “Notes” we want to focus on one event that was significant for markets: Fed Chair Janet Yellen’s speech at the Economic Club of New York. In it she essentially buried for dead expectations for the Fed to raise rates throughout 2016, expectations that she herself had been fostering for the last year or so.
In December 2015 the Federal Reserve raised interest rates for the first time since the Great Recession. At the time, the Fed suggested it could raise interest rates as many as four times over the following year. Bond markets, however, were skeptical, expecting at most two hikes during 2016. As it turns out, the Fed has not touched them since, and Yellen’s Economics Club speech marked her coming over to the side of the bond market. The Fed currently plans to raise rates only gradually over the next few years, and expectations are now for only one hike this year and for short-term Treasury rates to stay below 1% for another 3+ years.
In her speech, Chair Yellen harkened back to our economics classes of yore, reminding listeners that the Fed can only control short-term rates, and that investors—some refer to “The Market”—control long-term rates. The problem for the Fed is that the “Fed funds rate”, the rate which the Fed raised in December, is near zero and can hardly go any lower. Prior to the December rate hike, it had been below 0.25% since the beginning of 2009—that’s almost 7 years! Even now, at the time of writing, it stands at only 0.37%.
With rates so low, the most effective tool Chair Yellen has to influence long-term interest rates is what she says. Her speech in New York confirmed to bond investors that she now sees things as they do. And with the economic uncertainty that seemed to rise up in the first quarter of this year, her outlook for lower rates is a relief to investors.
So while the Fed’s funds rate remained unchanged, interest rates on 10-year Treasury bonds fell from near 2.3% at the end of last year to near 1.8% at the time of writing. As Chair Yellen pointed out, the bond markets do her work for her when they respond to economic developments and her words.
Keeping her options open to eventually influence 10-year rates in the other direction as well, she made clear in her speech that the Fed’s monetary policy is ever evolving and that it will respond to the economy’s twist and turns. She also wants to remind investors that there never was nor is now a set path for interest rate hikes in the future.
Like any good “eight armed” economist, Yellen presented several positive economic trends that represent the “one hand(s)”, and countered them with several “other hand(s).” On the positive side, employers have added 230,000 jobs a month for the last three months, the unemployment rate has continued to fall, consumer spending appears to be expanding, and the housing market continues its recovery. The “other hands” include continuing weakness in manufacturing and exports and declines in capital spending, which themselves are the result of weak global demand, low productivity gains, and a strong dollar.
From the rest of Yellen’s speech, it is clear that she anticipates the “economic headwinds” (the negative effects of the “other hands”) to lesson over the next 24 to 26 months. That’s a long enough time for any number of possible unforeseen developments to potentially impact the global economy, whether for good or bad.
If there is anything we can take away from Janet Yellen’s speech, it is that uncertainty is certain. While she is voting one the side of caution right now, she left open the possibility to change her mind in the future. With the “one hand(s)” and the “others,” the Fed seems to feel pretty confident about the uncertainty of their forecast.