Yellen's Hint at September Hike in Jackson Hole Speech, Markets Wary

In her Jackson Hole speech, the Fed chair reiterated the reactive nature of regulative response, also hinting at possible increases in base interest rates. Yet, as macro indicators remain feeble, market participants responded sheltering capital in Treasury bonds.

Kristian Rouz — Federal Reserve Chair Janet Yellen delivered her long-anticipated speech on policy and economic outlook at the mountain resort of Jackson Hole, WY, in the early hours on Friday. The US economy, she stressed, is gaining momentum at a pace sustainable enough to possibly move base borrowing costs up as soon as in September. Yet, aside of that notion, the central bank chair's speech sent a wave of doubtful frustration across the markets and broader economy, as Yellen provided little clarity addressing the current problems such as slowing growth, declining corporate profits, underperforming inflation and volatility in select segments of domestic debt market.

On Friday, representatives of many central banks from across the world, as well as academics and observers, gathered in Jackson Hole, WY, to discuss certain likely developments in the global economy and monetary and fiscal policies, as well as to try to figure out whether international trade in goods, services and capital would likely go in the light of Brexit, US elections and emerging markets' steady grind to a halt. Yellen did not explicitly say when the Fed will undertake another hike in rates, rendering market participants unsure if such a move would ever be viable.

A wider speculation of the Fed turning back to loosening monetary conditions is gaining prominence in many market participants' minds, expecting either negative interest rates policies (NIRP), helicopter money, or a return of zero interest policies coupled with a yet another round of monetary easing (Fed's bond-buying program, wrapped up in 2013-2014).

"In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months," Yellen stated, also remarking that the regulator is still committed to its "gradual" approach to policy adjustment. 

Following Yellen's speech, Goldman Sachs raised their chances of a September hike from 30% to the current 40%, whilst in the open market the odds of a September hike dropped from 32% to 26% in the light of the remarks.

Moreover, the 2-year/30-year Treasury yield curve (serving as an indicator for near-term macroeconomic developments) flattened to its December 2007 condition following Yellen's remark, narrowing the gap to 1.43%. The Treasury curve reflects bond market dynamics, providing evidence of the pace of capital allocation into havens, and a flatter curve indicates wider disinvestment in the real economy, typically signaling a looming recession.

That means, certain market segments have no credibility in the Fed's policies, and such a sentiment is already prevalent in the broader market, as suggested by the discrepancy in Goldman's and wider market bets of the odds of a September hike. In such an environment, the policy transmission between the Fed and the economy might be increasingly dysfunctional, meaning it does not really matter what policy moves and when the Fed undertakes. A recession is seen as "inevitable" by some market participants.

"There were some people in the market who expected that she would invoke September and that was probably the wrong thing to expect," Thierry Wizman of Macquarie Group, a Sydney, Australia-based global investment bank, said. Yellen's message was "a whole lot of nothing," he added, eyeing a 60% chance of a hike in December, and two more hikes to follow in 2017.

Yellen, however, stirred even greater confusion in the market, saying that in the timespan between now and the end of 2018 the base borrowing costs might be anywhere between zero and 4.5%, thus confessing the Fed's approach to policy is reactive rather than proactive.

"Monetary policy is not on a preset course. Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy," Yellen said.

However, the Federal Reserve's mission is defined as, among other things, "conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates."

Yellen's approach is the extremity of passive delivering on the central bank's main function.

"Based on the historical accuracy of private and government forecasters, (there is) a 70 percent probability that the federal funds rate will be between 0 and 3-1/4 percent at the end of next year and between 0 and 4-1/2 percent at the end of 2018," Yellen said.

Such a confession from the central bank head who does not know what their own policies are, complicates the outlook on growth and investment for the US and global economy, as costs and availability of credit are simply unknown in the short-to-medium-term, let alone longer-term projects and goals.

"They're willing to be patient when the economy encounters shocks," Laura Rosner of the New York branch of BNP Paribas said. "But absent shocks, if the data are confirming their outlook, which they are right now, then they think it's appropriate to make gradual hikes."