Yellen’s hawkish testimony: Rate increases ahead

The strong performance of asset prices in the post-2008 era remains in our view largely attributable to lower than expected growth rates being offset by much looser than expected monetary policy. However, as expressed recently by Bank of England Governor Mark Carney “..we’re coming to the last seconds of central bankers’ fifteen minutes of fame”. If, as we believe, central banks are in the early stages of stepping back from unconventional monetary policy this is likely to have significant implications for asset prices.

Yesterday, Fed Chair Yellen’s prepared statement to the US Senate committee included the following paragraph on the direction of monetary policy:

“Incoming data suggest that labor market conditions continue to strengthen and inflation is moving up to 2 percent, consistent with the Committee’s expectations. At our upcoming meetings, the Committee will evaluate whether employment and inflation are continuing to evolve in line with these expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.”

We believe this statement puts a March interest rate increase back on the table, as a mere continuation of current trends is now a sufficient condition to raise interest rates. Taken together with previous comments indicating the desirability of raising rates earlier and more gradually rather than later and abruptly, deferring a rate increase in March would raise questions over the Fed’s communication policy. If anything, this represents a micro-flip/flop in Fed thinking towards a more hawkish stance, perhaps in response to rising equity prices.

Exhibit 1: Fed has maintained low real interest rates (inverted scale) longer during this cycle

We believe investors who have been systematically caught off-guard by the Fed’s dovishness, going as far back as the 2012 expansion of the QE program, may be reading but not properly absorbing these communication signals. Following the resurgence in commodity prices, headline inflation is increasing rapidly and US unemployment is close to target levels, Exhibits 1 and 2. Given the data, the Fed’s forecast of three rate hikes in 2017 do not seem improbable to us.

Exhibit 2: Headline inflation rates moving rapidly higher and now close to target

We believe investors should maintain a cautious view on equity markets globally as high valuations are likely to be at risk from tighter US monetary policy. A stronger dollar is also a likely to act as a headwind on emerging markets given the global reliance on US dollar funding. These are not new views but investors seem to be struggling to absorb the relatively clear hints from US policymakers that the renormalisation of US interest rates is a live 2017 story.