All eyes on Janet Yellen at Jackson Hole

Janet Yellen, chair of the U.S. Federal Reserve, testifies during a Senate Banking Committee hearing in Washington, D.C., U.S., on Tuesday, June 21, 2016. Yellen offered a subtle change to her outlook from less than a week ago, saying she and her colleagues were on watch for whether, rather than when, the U.S. economy would show clear signs of improvement. Photographer: Pete Marovich/Bloomberg©Bloomberg

Deciphering the Federal Reserve’s messages is a task to test the sharpest of codebreakers. This week left some traders so flummoxed by the latest communications from US policymakers that one could barely contain his frustration.

“Fed watching, in retrospect, has been the single biggest waste of my time in the past two years,” says London-based hedge fund manager Stephen Jen. “Sometimes I feel like we have all been taken for a ride by the Fed.”

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In the midst of a quiet August, it is tempting to assume that a dose of mixed Fed messaging points to another “no change” decision from the central bank regarding interest rates when it meets next month.

That’s the message from markets as US equities have advanced further into record territory. Federal funds futures are pricing in only an 18 per cent probability of a September rise, while the index that measures the dollar against its major peers is hovering near its lowest for two months. The index has fallen 4.3 per cent this year.

It’s been the story of the year: a cautious central bank has seen an insufficiently compelling case to lift rates from between 0.25 per cent and 0.5 per cent.

This time, however, a number of market commentators are prepared to break with consensus and talk up the prospects of a September rise. Take Alan Ruskin at Deutsche Bank.

Dollar strength used to be seen as a major obstacle to a Fed rate rise, says the FX strategist, tightening financial conditions to the point where it slows the US economy.

But that process can go into reverse, argues Mr Ruskin. “A less strong USD, easing financial conditions and associated better data, adds to Fed tightening prospects, in turn eventually supporting the USD.’’

Or Steven Saywell, global head of FX strategy at BNP Paribas. The market is “way too complacent” in expecting the Fed to stand pat, he says. “We think they go.”

Ignore the Fed minutes, which had “something in there for everyone, but no smoking gun”, says Mr Saywell. What the minutes of policymakers’ July meeting did not take into account was last month’s jobs growth, which came in at a better than expected 255,000, putting the three-month average at 190,000.

“The Fed is biased towards hiking,” Mr Saywell says. “They will hike unless they see a downside risk.”

Those risks may be highlighted by the central bank’s chair Janet Yellen when she speaks at next week’s annual Fed symposium at Jackson Hole, Wyoming. It is a gathering given added spice by calls from San Francisco Fed president John Williams for a broad rethink on monetary policy, arguing the Fed should increase its inflation target in order to open up opportunities to push up rates.

That throws up the prospect of “now or never” for the Fed, say Barclays economists Michael Gapen and Rob Martin.

“Either labour markets are healthy enough to warrant a near-term rate hike, or something is fundamentally amiss with the economic environment,” they argue.

The difficulty interpreting the latest minutes stemmed from the range of opinions being expressed. Some advocated an immediate move in July, others said the time was rapidly nearing, whereas a further group insisted more data were needed to gauge the health of the economy as they called for patience.

Analysts also face the added complexity of differentiating between views expressed by the full range of participants in the Fed meeting, and those of the core group who are currently active voters on the Federal Open Market Committee — the body that makes the decision on rates.

The FOMC members include Mrs Yellen and the Fed Board’s governors, as well as the New York Fed president and a rotating cross-section of other regional Fed presidents.

One cluster of people on that powerful body were minded to pull the rate-raising trigger soon, the minutes suggested. Some members, the minutes recorded, “anticipated that economic conditions would soon warrant taking another step in removing policy accommodation.”

A key question is whether one of them is Bill Dudley, the president of the New York Federal Reserve, whose views are often aligned to those of Mrs Yellen and has recently been making hawkish noises. In an interview with Fox Business Network this week, Mr Dudley said markets were underpricing the odds of a second rise in official rates following the December lift-off and that a move could come as soon as next month.

Investors, however, have been unimpressed by Mr Dudley’s admonitions. Some simply don’t believe the central bank would run the risk of unsettling the markets by lifting rates so close to a presidential election in November — even though it has been willing to change policy in close proximity to polls in the past.

If it wants to go, they argue, it should wait until December. They also point to sub-target inflation as reason for the Fed to sit tight.

The market’s pricing of the likelihood of a move matters. The Fed will be deeply reluctant to pull the trigger if markets are caught unawares, because it does not want to provoke financial convulsions akin to those seen during the “taper tantrum” of 2013.

The upshot is that it would take a firm hint from Mrs Yellen in Jackson Hole on Friday that a near-term move is possible, coupled with a punchy set of jobs figures in early September, to shift the markets towards accepting the potential for a move next month.

The situation bears some resemblance to the debate around Jackson Hole this time last year, when some Fed policymakers were publicly toying with a September increase. In the end the Fed held fire, after market turmoil erupted following China’s unexpected reform of exchange rate policy which led to the renminbi’s devaluation.

This August has thus far been more benign, giving the Fed more scope to raise in September. By the end of next week it should be clearer whether Mrs Yellen is willing to seize the opportunity.

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