Yellen's Testimony Not Surprising: Fed Has More Work to Do

Observations on the Capital Markets – Week Ended November 15, 2013

  • Yellen’s testimony not surprising: Fed has more work to do
  • Last week in the capital markets: The allure of currency devaluation
  • U.S. economic data: Generally consistent with continuing modest growth
  • A sign of sanity from the EPA
  • Watching developments in Europe, Japan and China

Yellen’s Testimony Not Surprising: Fed Has More Work to Do

Janet Yellen’s Senate testimony in last week’s confirmation hearings was very dovish and offered no real surprises. She did not signal or hint at any change in Fed policy (it was a confirmation hearing), but suggested that the best way to achieve an exit from unconventional policy is to deliver a stronger recovery . . . and the Fed has “more work to do” to support that recovery. The risk that she will not be confirmed is considered negligible.

Her testimony suggested that a QE (quantitative easing) taper might not be imminent, and that she felt the benefits of QE “exceed the costs”. She did, however, admit that QE “cannot continue forever” and stuck to the “data dependent” line: taper timing will be driven by economic data, especially the labor market outlook. While she didn’t rule out a December taper, the odds-makers lowered the line.

On Asset Bubbles and Sources of Systemic Risk

Yellen said she would like to see monetary policy used “first and foremost” to promote macroeconomic (rather than financial stability) goals. She downplayed the risk that the Fed’s balance sheet poses a threat to financial stability and suggested that she saw little cost or downside in further balance sheet expansion. She said she does not presently see threats to financial stability coming from market excesses. While she said the Fed has no responsibility to support the stock market, she noted that stocks appear inexpensive relative to bonds. As far as I can tell, she was silent on the subject of bond market valuations.

Last Week in the Capital Markets: The Allure of Currency Devaluation

Currencies: Janet Yellen’s Senate testimony was dovish, but Japanese Finance Minister Aso made a stronger statement, saying “It is necessary to have the option to intervene in currency markets.” Markets responded by bidding the Yen down 1% against the dollar and down 2% against the euro (the ECB won’t print). Emerging market (EM) currency returns were mixed, but most strengthened against the dollar on Yellen’s testimony.

Bonds: Major U.S. bond indexes posted small gains, while European sovereign yields were generally slightly lower. Japan’s 10-year JGB yield jumped 4 basis points (bps) last week – a big move for JGBs

Equities: MSCI Japan was up over 5% in U.S. dollar terms (more in yen terms) on strong profit reports and the perceived positive impact of currency devaluation. The S&P 500 was up about 2%; MSCI Europe and MSCI were up a little.

Commodities: Gold was down 1% before Yellen’s testimony, then rallied to end the week roughly flat. WTI oil ended the week down roughly 1%. Corn fell 1% when the EPA proposed a revised ethanol mandate (more below).

U.S. Economic Data: Generally Consistent with Continuing Modest Growth

  • Company earnings overall are on track for 5% year over year (y/y) growth, while labor productivity is flat and unit labor costs are up 1.9%.
  • The trade deficit was slightly larger than expected on soft exports and a wider petroleum trade gap. October import prices fell largely due to lower energy prices.
  • The International Energy Agency predicted the U.S. will pass Saudi Arabia and Russia to become the world’s largest oil producer by 2015.

A Sign of Sanity from the U.S. Environmental Protection Agency (EPA)

Background: A 2007 law mandates that certain volumes (rising each year) of ethanol be blended into gasoline. This has sparked a corn farming boom: roughly 40% of the U.S. domestic corn crop is now converted to ethanol and 15 million more acres were planted with corn this year than before the mandate.

Aside from the (dubious) economic and environmental implications of corn ethanol, the mandate is having a “blend wall” problem. Gasoline consumption is lower than expected when Congress set the ethanol targets in 2007 (partly fewer miles driven, partly better mpg). Using the amount of ethanol mandated in 2014 would push the ethanol content to over 10% of what comes out of the pump, which would apparently void most manufacturer warranties and may harm car engines. So, the EPA proposes to lower the mandate. As I read it, the proposed volume cut is about 6% of 2013 levels but 15% of what the mandate was set to grow to in 2014. Corn prices fell 1% on the news. Ethanol producers who ramped up to meet the mandated demand are not happy. Meanwhile the “big oil” and the “renewables” lobbying firms are gearing up for a big PR battle.

Watching Developments in Europe, Japan and China

In Europe: Gradual improvement. The Bank of England upgraded its economic outlook; and it appears that Spain and Ireland are ready for clean exits from their rescue programs. This was Italy’s 9th consecutive down quarter…but we’ll see positive growth in Q3 if the improving trend holds.

In Japan: Happy Anniversary, Abenomics! A year ago, former Prime Minister Noda called for the elections that brought Shinzo Abe to power. Since then, the Bank of Japan’s balance sheet has tripled, the yen is down 20% against the dollar and MSCI Japan is up 80%.

As expected, Japan’s Q3 GDP growth was soft, at 1.9% (annualized), restrained by falling Asian demand rising energy imports. Q4 GDP growth is widely expected to be over 3%.

In China: No Surprises. The communique of the Chinese Communist Party’s 3rd Plenum emphasized giving competition and market forces a “decisive role” in the economy, but didn’t suggest changing the role of state-owned enterprises or loosening political control.

Electricity usage was up 9.5% y/y in October and CPI rose as well. Monetary policy is getting slightly tighter: SHIBOR was 4.45%.

The country’s 1-child policy will be (slightly) loosened – any couple in which either parent is an only child can now have two children.

Data Sources: The Wall Street Journal, Financial Times, Bloomberg.

© Pioneer Investments

Read more commentaries by Pioneer Investments