While the markets have been generally lacklustre in the past two days, much of the enthusiasm associated with the last hour spike on both Monday and Tuesday had to do with optimism involving a significant relent by Janet Yellen during her semi-annual 2-day testimony in Congress starting tomorrow at 8:30 am.
And while Yellen will certainly have a tough time reconciling the worst start for the S&P since 2008, or the accelerating slowdown across the global economy with the Fed's dot plot which still forecasts 4 rate hikes in 2016, some such as Citi's Steven Englander believe that Yellen will not only not relent as much as consensus believes she will (negative rate odds are well over 10% by the end of 2017), but will "deflate some of the recent enthusiasm" and "unwind some of the panic buying" of US fixed income.
While Englander admits that while the prevailing sentiment will be one of more of the same by Yellen, and will likely be accompanied by selling of rallies by traders, there is an odd chance that Yellen will try to break out of the trap the Fed has put itself in, and capitulate with a dovish relent, unleashing a major stock surge.
This is how she would do it:
The dovish surprise is if she explicitly removes March from the hiking calendar (which would be Draghi-esque in front running the FOMC), broadly hints at a delay or expresses concern on downside risk to long term inflation or structural stagnation. The intention would be to show US households, business and investors that the Fed has their back.
The Citi strategist notes that there is a major problem with this admission of policy error: "investors would likely interpret removing March from the calendar as a prelude to endorsing the much bigger unwind of policy rate hike expectations that is now priced into asset markets."
Moreover, it is unclear whether the dovishness would be viewed as asset market friendly or as affirming the economic and asset market slump without really offering any policy alternative that would be considered effective. She may even be pressed on what policies the Fed would put in place if these downside risks manifested themselves. So there is a risk that a soothing message will end up as being viewed as an opportunity to sell from better levels.
And then this:
It is unlikely, however, that pointing to negative rates or QE4 would work, as investors are increasingly skeptical that more of the same policy mix would be effective in hitting final goals.
In other words, after massive policy errors by Draghi in December and Kuroda in January, Yellen may complete the trifecta by panering to a petulant stock market, and in the process not only not send it higher, but destroy the last shred of cred the Fed may have had, leaving the central bank cabal with just one option, the final one: money paradrops, the kind many serious economists have already called for.
Englander sums up his analysis with a baker's dozen of questions which Yellen will provide hour-long, single sentence, coma-inducing answers to.
From Citi's Steven Englander
Yellen testimony meets policy ineffectiveness meets 'sell everything' mood Fed Chair Yellen will confront political, asset market and Fed demons at her testimony this week. The narrative that she faces is that the US economy and asset markets are being sucked into the downdraft caused by oil, China, EM, reserve manager and SWF asset selling, commodities, currency war, the strong USD, weak European banks, weak Japanese banks, weak US banks and policy ineffectiveness & to name a few. My expectation is that she will deflate some of the enthusiasm for negative rates, arguing that the Fed is far from seeing the necessity, even if that is a policy option that remains open in extremis. This could unwind some of the panic buying of US fixed income and provide some support for USD if she is convincing enough. However, the impact may not be long lasting. I have detected very little enthusiasm among clients for positioning going into the Yellen testimony. Her baseline intention is to convey optimism on the US economic recovery and the ultimate attainment of inflation goals, and awareness watchfulness on risks that asset market disruptions and foreign economic weakness could spill over into the US economy, but no presumption that such shocks will derail the expansion in either the short or long term. On rates she is unlikely to go beyond the January Statement, which retained data dependence, did not write off hikes on any time horizon, but acknowledged greater risk. Yellen s sweet spot is to express strong confidence in recovery, tempered by awareness that domestic and international financial market strains could spill over into the domestic economy. However, what is crucial is that she also convey that Fed watchfulness does not mean that they will give financial markets a veto on continued Fed hiking. She is likely to emphasize the improvement in income distribution and some tentative indications that wages are beginning to respond to the tighter labor market. Part of the message is that the rapid increase in real labor compensation will support consumption and housing (A Working class hero is something to be) and be enough to carry the economy even if business investment is subdued. She will convey satisfaction at signs that wages are rising but try and diffuse any expectation that this means a faster Fed tightening cycle. The weakness in headline inflation will be blamed almost entirely on commodities, the USD and weak emerging economies. Her hope would be to unwind some of the bearishness that has engulfed asset markets, and this would be supportive for USD, rates and equities. However, market pessimism may be so deep seated that good news is viewed only as an opportunity to sell at better levels. The dovish surprise is if she explicitly removes March from the hiking calendar (which would be Draghi-esque in front running the FOMC), broadly hints at a delay or expresses concern on downside risk to long term inflation or structural stagnation. The intention would be to show US households, business and investors that the Fed has their back. The problem is that investors would likely interpret removing March from the calendar as a prelude to endorsing the much bigger unwind of policy rate hike expectations that is now priced into asset markets. Moreover, it is unclear whether the dovishness would be viewed as asset market friendly or as affirming the economic and asset market slump without really offering any policy alternative that would be considered effective. She may even be pressed on what policies the Fed would put in place if these downside risks manifested themselves. So there is a risk that a soothing message will end up as being viewed as an opportunity to sell from better levels. The hawkish risk is harder to define. Market pricing is dovish, bordering on depressed, so anything upbeat should be viewed as hawkish. However, client conversations suggest that investors expect this kind of upbeat message and the key will be she can go beyond a pro-forma expression of confidence and convince investors that 7 bps is on the low side for 2016 Fed hiking expectations. Maybe a repetition of Fischer's But we have seen similar periods of volatility in recent years that have left little permanent imprint on the economy with great emphasis would succeed. A strong assertion that the Fed expects the US economy to rebound would be viewed as hawkish and USD positive, but in current circumstances it may not be bullish for asset markets if investors see it as misguided. Paradoxically, a convincing affirmation that the Fed has tools that would be effective in stimulating the economy would support the USD and asset prices. This is not hawkish in the normal sense but would suggest that the despair on long term outcomes is misplaced. It is unlikely, however, that pointing to negative rates or QE4 would work, as investors are increasingly skeptical that more of the same policy mix would be effective in hitting final goals. Given that it is an election year there will likely be more circus in the air than normal. A selection of questions she is could face: 1) How much has the US economy slowed? 2) Is the slowdown a blip or a more prolonged slump? 3) What are the risks of recession in coming months? 4) Is fiscal policy the right tool to stimulate the US economy? Would the Fed adjust its balance sheet higher to facilitate fiscal stimulus? 5) To what extent did Fed lift-off contribute to these economic risks? 6) How does she assess the contribution of lower oil to the US economic and financial outlook? Is there a point at which it shifts from being a plus to a minus? 7) How material are the problems in China, EM and global banks to the US economy? 8) What tools does the Fed have to deal with a future slowdown? 9) How keen are they on negative rates, are negative rates permitted under US law and, if they are not keen, what else is there? 10) Will she rule out March? 11) Does the Fed think other central banks are engaging in currency wars and what is the appropriate response? 12) Does she expect CNY to go up or down and what effect should it have on the US economy? 13) How automatic are Fed hikes if wages and inflation edge up and asset markets remain uncertain