Yellen Transition – A Smooth Ride?

18 February 2014

Janet Yellen, Chairperson of the Federal Reserve

Janet Yellen, Chairperson of the Federal Reserve

This week we take a brief look at the market just a few days into Janet Yellen’s term as chairwoman of the Federal Reserve – they have not gone unnoticed by any means. The stock jocks were certainly happy (S&P chart below) after her testimony at the House Financial Services Committee, but before I go further into the market’s reaction, let’s look at some of her major talking points:

–          The economic recovery gained greater traction in the second half of last year. Real gross domestic product (GDP) is currently estimated to have risen at an average annual rate of more than 3-1/2 percent in the third and fourth quarters, up from a 1-3/4 percent pace in the first half.

–          The unemployment rate has fallen nearly a percentage point since the middle of last year and 1-1/2 percentage points since the beginning of the current asset purchase program.

–          Those out of a job for more than six months continue to make up an unusually large fraction of the unemployed, and the number of people who are working part time but would prefer a full-time job remains very high.

–          I am committed to achieving both parts of our dual mandate: helping the economy return to full employment and returning inflation to 2 percent while ensuring that it does not run persistently above or below that level.

A lot of the rhetoric remains from the Bernanke era, and expectedly so. Clarity and continuity in the language used to guide market participants through the recent crises (global financial crisis, PIIGS fallout) remains vital. We’ve already had an overreaction to EM currency declines early in 2014. Most observers took Yellen’s testimony as a signal that the Fed would continue to reduce, or taper, its monthly asset purchases by $10bn at each of its Open Market Committee meetings (Financial Times). Largely positive indications right?

Source: Bloomberg

Source: Bloomberg

I would agree in the main, but I am left with a few more questions than answers, namely;

1.    How uneven is unemployment recovery exactly?

Source: Market Watch (WSJ)

I would have mentioned in previous blogs that the low labour participation rate significantly skews the unemployment data. The chart above says it all, with the “true” (not to confuse their use of “real” with inflation adjusted levels) unemployment rate being closer to ~15%. In Yellen’s own words, “These observations underscore the importance of considering more than the unemployment rate.” The 6.5% target may really become a shifting goalpost until full employment is anywhere near in sight.

 2.  Was there any reconsideration of tapering when EM currencies (and later on credits) got slammed?

Behind closed doors I would venture that the answer to this may have been ‘Yes’ especially with words like ‘contagion’ being tossed around. However, a very interesting counterpoint from Christopher Vecchio, currency analyst at DailyFX is that:

“The Fed cannot and will not base policy outside of the context of its dual mandate – and there is no reason to believe that heightened volatility in emerging market currencies and bond markets will have any impact on US price stability or the attempt to foster maximum employment. If it chooses to ‘throw a bone’ to emerging markets, there will be an upheaval in currency markets as the credibility of the Fed’s path is immediately drawn into question.”

In terms of the interest rate path going forward, Yellen; who has labelled the U.S. economy as still “weak,” added that the Fed plans to hold short-term interest rates at zero “well past” the time the jobless rate falls below 6.5%. With this in mind, and tapering which has been largely priced in, one can expect rate volatility to be somewhat constrained over the short term. Over the last six months, the 10-year treasury yield graph below shows movement within a 50bps range (2.50%-3.00%).

Source: Bloomberg

Source: Bloomberg

EM currencies wilted due to previous uncertainty about tapering, but the likely stability there going forward should put some minds at ease. The impact of the withdrawal of quantitative easing is varying from country to country, but those with external imbalances or a reliance on external funding have been most vulnerable (Moody’s). Think Argentina, Brazil, South Africa, Egypt and Turkey here.

Latam bonds in particular were hit along with most of EM, but we’ve since seen better buying in short-end VENZ and PDVSA (with nearly an 18% yield on paper maturing October 2014 on PDVSA). New issues have no come to market as frequently, but Telemovil, Unicomer and Braskem to name a few have done well in a difficult environment.

Asia toward to the end of January saw the Nikkei 225 index fall as much as 3%, and Australian stocks shed 1% while Hong Kong’s Hang Seng fell 1.4% at its open. The “flight to safety” also saw the Japanese yen and Swiss franc gain value against the US dollar, along with increased demand for gold and government bonds (BBC).

With Europe still on the mend, we can expect very accommodative measures retained in the medium term. Another trend expected to persist is the deleveraging from emerging Europe by Western banks. Western banks had further scaled back positions in emerging Europe between June and September last year. Since 2008, the cumulative deleveraging by big banks equates to almost 10 percent of the region’s GDP, if Turkey and Russia are excluded from calculations (Reuters).

An alternative gauge of market sentiment would be the Baltic Dry Index. This shipping and trading index gives market participants insight into global economic health. As a leading indicator of economic growth, the Index – shown in the graph below reveals that there are grounds for pessimism in global trade prospects going forward. Many favour the use of the index since there is almost no speculation.

Source: Bloomberg

Lastly, Credit Default Swap (CDS) spreads show how costly ‘insurance’ against non-payment on a security is. EM troubles, while still quite relevant, are not reasons to panic as they were in January, and the graph (Markit CDX Emerging Markets Index) below shows just that. To give you an idea of the range of spreads per region:

CDX Investment Grade: 64.19 bps

iTraxx Europe: 73.26 bps

iTraxx Japan 81.00 bps

CDX Emerging Market 107.41

iTraxx Asia Ex Japan IG 132.00 bps

CDX Latin America: 450 bps

Source: Bloomberg

Source: Bloomberg

In Firstline Securities’ inaugural Portfolio Construction Seminar held just a couple weeks ago, many of the speakers touched on the uncertainty in the U.S. jobs market, but all agreed that the overall economic picture appears to be improving. Going forward, I urge you to not only pay attention to the data, but more importantly the quality of it. These numbers (jobless claims, non-farm payrolls) significantly impact treasury yields and subsequently the performance of your portfolio. The consensus view on the rate of tapering to the tune of USD10bn per month, should at least give you some sense of stability in comparison to the numerous other moving parts you have to consider.

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Gerard Stephens,


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