Yellen changed the near-term dynamics in the capital markets - BBH

Research Team at BBH, suggests that with 17 simple words and the help of clarification from her deputy, Yellen changed the near-term dynamics in the capital markets.  

Key Quotes

By saying that "...I believe that case for an increase in the federal funds rate has strengthened in recent months," Yellen placed her marker down.

Yet the market was initially confused.  It thought the Chair was indicating a December hike not a September move, and that meant one hike not the two the June dot plots implied was thought to be appropriate by the FOMC.  Vice Chairman Fischer quickly followed his boss and explained that she implied no such thing.  Nothing she said had ruled out a September hike or two hikes this year. 

And to sweeten his treat, Fischer advised watching this week's employment data closely.  What more can be said?   The employment figures are among the most significant reports in the monthly cycle.  They are also volatile and difficult to forecast, as the May's drop out of the blue reminds us. From nearly any other central banker it would seem reckless to link monetary policy so directly to a high frequency number, but Fischer is Fischer.  He has had a distinguished career as the chief economist at World Bank and the Governor of Israel's central bank.  He was on both Bernanke and King's dissertation committees.   

Still, it does not set right, but the market took the bait and ramped up the odds of a September hike to 42% from 32% the previous day.   It is the greatest probability in a month.   Most economists do appear to be forecasting the US economy to accelerate.  The Bloomberg survey median has the economy growing 2.6% at an annualized pace in Q3, and 2.3% in Q4 snapped the three-quarter streak of sub-2% growth.  The Atlanta Fed GDPNow tracker has it at 3.4%, and the NY Fed's tracker is at 2.8%. 

The immediate challenge, however, is that in the past two months (June and July), net job growth overshot its trend.  Consider that the two-month average is at 274k.  This is the highest of the year and was only surpassed twice last year.  This year's average is 186k, and the 12-month average is 204k.   The median guesstimate is for around 180k.   A  report of less than 144k would be disappointing.  That was job growth in April, the second lowest of the year besides May's inexplicable 24k increase.

Consumption has also grown faster than sustainable.  Consumption in Q2 was revised to 4.4% from 4.2%.  It is only the third quarter since the Great Financial Crisis that consumption exceeded 4%.  This will b evident in the July personal consumption expenditures.  In Q2 PCE rose by an average of 0.6% a month.  This is twice the 12-month, 24-month and 36-month average of 0.3%.  The median forecast for July is 0.3%.   The same will be evident in real spending.  The Q2 average of 0.4% is twice the long-term averages, which are stable at 0.2%.   Auto sales in August are also expected to have slowed, though remaining at elevated levels above 17 mln annualized vehicles.

For most investors and market participants, it might not make a significant difference whether the Fed hikes in September or December.  The Federal Reserve's leadership has put the market on notice that it is coming.   This is an example of transparency as well as taking into account the interests of other stakeholders.  However, the increased prospects of a Fed hike may spur profit-taking in many summer rallies in risk assets, like the 16%+ rally in emerging market stocks since late-June, or the 11.25% rally in the MSCI World Equity Index of developed countries.

The Federal Reserve stands in stark contrast with the European Central Bank, the Bank of Japan and the Bank of England.  These central banks are actively engaged in easing monetary policy and, if anything, the next steps will be more not less.   This week's data from the eurozone will favor those forces on the Governing Council that want to extend the asset purchase program from the current soft end date of March 2017.   

CPI for August is expected to be confirmed at 0.3%.  It has averaged 0.1% over the past three months, which matches the 24-month average.  It is better than the six-month average of minus 0.1% or the 12-month average of zero.  However, officials cannot be satisfied.   Unemployment may ease, but at 10% it is still too high in most countries.  The PMI reports are give no reason to think that the Eurozone economy is accelerating.”