Janet Yellen’s room for manoeuvre is shrinking

The dramatic repricing of market expectations of an interest hike in March — from close to 30% to over 80%— may even force the hand of Yellen when she delivers a speech on Friday

A file photo of  Federal Reserve Chair Janet Yellen. Photo: Bloomberg
A file photo of Federal Reserve Chair Janet Yellen. Photo: Bloomberg

Whether the Federal Reserve decides to hike or not when its policy-making committee meets on 14-15 March, the movements in fixed income this week should serve as a warning to all those who have grown to believe — wrongly as it turns out — that the central bank is destined to follow markets rather than lead them.

Indeed, the dramatic repricing of market expectations of an interest hike in March — from close to 30% to more than 80% in just a few days — may even force the hand of Chair Janet Yellen when she delivers a speech on Friday.

In a notable display of unity and uniform messaging, the presidents of three regional Feds — Dallas, San Francisco and importantly, given its position in the FOMC, New York — came to state the stronger case for an early interest rate hike. This was supported by the remarks on Wednesday evening by Lael Brainard, widely regarded as one of the most dovish board governors.

With every one of the Fed speakers this week, the implied probability of a rate hike rose, as did the yield on the Fed-sensitive shorter maturities Treasuries, including the 2-year note, which now trades at levels not seen since 2009. The spillover was felt well beyond the US: German yields rose despite the increase in political risk associated with the French elections.

Admittedly, it wasn’t just Fedspeak that moved the markets. The case for an early interest rate also got a boost from solid US economic numbers, including a weekly jobless claim number at a low not seen for 44 years, as well as strong international data such as an upward surprise from the Chinese purchasing managers’ index. Add to that the exuberant stock market, which has been thrilled by the tone and general content of President Donald Trump’s first speech to a joint session of Congress. The delight was such that little attention was given to further delays of the specific details of the president’s intended pro-growth measures and their implementation timeline.

The question now is not whether this repricing was warranted. Indeed, a week ago, I argued that market participants were underestimating the probability of a March hike. The main question has become whether markets have moved too far. And the answer needs to await the 10 March jobs report and the numbers for wage growth in particular.

In the meantime, Yellen faces a tricky situation when she speaks on Friday. In a perfect world, she would have liked to retain greater policy optionality, especially ahead of the jobs report and, to a lesser extent, given the political fluidity in Europe. In terms of illustrative numbers, I would suggest that this would have involved an implied market probability in the 50% to 60% range. Instead, she confronts a much higher one. As such, any meaningful attempt to guide the probability significantly lower risks triggering quite a chorus of complaints about inconsistent Fed messaging.

We are sometimes reminded to be careful what we wish for. The Fed could well feel this way, though only in the very short term.

This week’s powerful demonstration of its ability to move the fixed-income markets comes with the risk of an initial overshoot that limits the immediate degrees of freedom for Yellen on Friday. Beyond that however, the health of the economy and the underlying stability of financial markets would benefit from a revitalized Fed strategy that is both able and willing to lead markets, rather than be led by them. Bloomberg

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