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SocGen's "Pretty Simple" Explanation Of Janet Yellen's Testimony

Did Janet Yellen really reverse so fast? Just two weeks after the Fed chair (and most other FOMC members) warned that “asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios", Yellen sent the Dow and MSCI World index back to all time highs, after what the market broadly interpreted as an unexpectedly dovish speech in which the one line that stood out was that “because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get a neutral policy stance” suggesting the Fed's entire dot plot is an error and that the "terminal" Fed Funds rate will never make it to 3%, or even 2% for that matter.

Of course, algos and carbon-based traders were delighted by the phrasing and unleashed the latest buying spree, however did the market get ahead of itself? SocGen had a "pretty simple" explanation of what really happened yesterday, saying "don't overcomplicate it...As long as US interest rates consolidate and fears about a move to well north of 2.5% remains in check, the positive tone in emerging markets that prevailed prior to mid-June should resume”. All I can add is that this as true of credit, equity and the broader FX market as it is of emerging markets."

In other words, while the jury is still out on whether Yellen has lost control of the market (alternatively, the market is 100% certain it has full control of the Fed), Yellen is not willing to tempt risk assets, and will keep the Fed's tone with a goldilocks range, that allows for a smooth, gradual increase in the S&P, until ultimately the central banks and stocks will be forced to a showdown. Until then, just BTFD if you can find one.

Here is SocGen's full note, courtesy of FX strategist Kit Juckes:

The main point of speculation about Fed Chair Janet Yellen’s semi-annual testimony to Congress may be about whether it was the shortest on record or not. The Fed plans to start reducing the balance sheet relatively soon (this year). “Additional gradual; rate hikes are likely to be appropriate over the next few years” told us very little. Neutral. Rates are very low but they will probably edge higher from here. I thought the observation that the fed isn’t interested in changing its inflation target but is keen to hit the target was perhaps the most interesting statement. This sounds a bit like a “cri de coeur”. Most of all, Chair Yellen’s testimony doesn’t support a lurch higher in real bond yields or in expectations about terminal fed Funds. The market has spent months guessing that the Fed will get rates above 2% but not as far as 3% and I didn’t hear anything to challenge that conclusion. So TIPS yields have once again made a short-term peak, are drifting in a range, as are nominal yields, and supporting risk sentiment across asset markets in general.

 

 

Jason Daw’s EM Strategizer sums it up. “It’s pretty simple.....don’t overcomplicate it...As long as US interest rates consolidate and fears about a move to well north of 2.5% remains in check, the positive tone in emerging markets that prevailed prior to mid-June should resume”. All I can add is that this as true of credit, equity and the broader FX market as it is of emerging markets. We get round two today, with the same (short) prepared remarks and a different set of questions.

 

The divergence between US real yields and the dollar continues. DXY peaked at the same time as DXY-weighted relative real yields did, and both are falling. It’s just that the dollar is falling a bit faster than a dumb regression would suggest. That has now been true for just over three months and isn’t likely to change quite yet. The softer tone to US yields caps USD/JPY, but puts a floor under EUR/USD. EUR/JPY has drifted down a bit but not dramatically and while Japanese politics bears watching, we remain bullish for a move towards 140, with the next leg up probably coinciding with another leg up towards 1.16 in EUR/USD.