Two notable events regarding stock and bond markets have occurred in the last twenty-four hours. One is comments from Fed Chair Janet Yellen that suggest she sees U.S. equity prices as elevated. The second is a wide-spread backup in yields in eurozone long-tern government debt. I see this constellation as increasing the likelihood of a rate hike if the Q2 macro data are sufficiently robust to allow for that hike.
Yesterday, I attended a conference hosted by Stanford Professor Anat Admati at the IMF, with a keynote conversation this morning from Fed Chair Janet Yellen and IMF Chief Christine Lagarde. I hope to have the opportunity to write something up on the topic of this conference, finance and society. But right now I want to focus on some remarks Yellen made regarding monetary policy, reaching for yield, and asset market froth. Now these are comments she has made before, most notably covered in a 2010 post I wrote called Yellen: “It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage”. So I don’t think there is anything new here regarding principle. The issue is timing and specificity.
What Yellen said in her conversation with Christine Lagarde is that monetary policy accommodation can lift asset prices by causing investors to reach for yield. And she said this in the context of a conversation about risks. First, she mentioned portfolio risks from insurance companies and other asset managers investing in illiquid assets in order to generate returns in a low-rate environment. She called this illiquidity dangerous given the runs on wholesale funding markets we had that precipitated the acute liquidity crisis that was the hallmark of the last financial crisis.
But Yellen also mentioned three asset markets by name: leveraged loans high yield, and equities as being markets where signs were that prices were elevated beyond levels historical benchmarks would suggest were appropriate. The first two markets, Yellen suggested, are elevated because of a reach for yield, meaning that the low-yield environment was causing asset managers to take on riskier assets in order to hit nominal return targets. The second market, she suggested, was elevated because term premiums had declined. And because these premiums were down, discounted cash flows from out years were more valuable, raising the value of equity securities.
When Yellen told us this, I got no sense from her that this was a motivation to raise rates. She made no direct connection between interest rate policy and financial instability. And I believe she did not do this because there is still a strong debate at the Fed as to what tools are most appropriate to use in order to deal with financial stability concerns. Moreover, Yellen’s prior 2010 comments suggest that her overriding concern on financial stability is the degree to which illiquidity and leverage can mix to cause instability. She is not concerned with ‘bubbles’ per se, unless those bubbles are funded with debt and leverage.
So I was left with the sense that this was like Greenspan musing about irrational exuberance in 1996, an event that remains a legacy of his era because of Robert Shiller’s book “Irrational Exuberance”. But Greenspan’s musings had no discernible impact on monetary policy actions or on longer-term market outcomes. The bull market continued for much longer. I would suggest we see this as a similar marker in time, something that is a hallmark of the financial environment we operate in but that will have few market or policy implications.
At the same time, today the sell off in government bond yields in Europe has gathered pace. Just two weeks ago, German 10-year bunds were yielding a record low of 0.05%. Now, they are trading at almost 0.80%. Other eurozone government bond yields have backed up in concert. And this has European equities selling off this morning. The dollar is now at $1.14 to the euro as the yield differential has diminished significantly. I do not have a view on why this violent backup in yields has occurred. But I do know that it is negative for European growth and dollar strength.
It is not necessarily the case that this move in long-term rates will have grave long-term implications. However, to the degree that US market froth and a weakening dollar combine with decent macro data, these are factors that will support an earlier rate hike from the U.S. Federal Reserve. By themselves, these events have no policy implications. However, in an environment in which the Fed is looking for an excuse to raise rates, these events provide support.
I believe there are multiple reasons the Fed might want to raise rates despite a negative Q1 GDP print. First, the Fed is concerned about the lags in monetary policy and believes acting pre-emptively is better than waiting for inflation to become entrenched. Yellen has spoken to this in the past. The Paul Krugman view that the Fed should wait until it sees the whites of consumer price inflation’s eyes is not the predominant view at the Fed. Kansas City Fed President Esther George, who is more hawkish than Yellen, also professed a second narrative of low rates leading to distortions in the economy that would disrupt long-term growth, one of the Fed’s mandates. And, then there is a third unspoken view that I discussed with others at this conference. And this goes to the Fed’s being able to re-load. Meaning they don’t want to be sat at zero when the next cyclical downturn comes. Why? Because yield curve steepness is a tried and true backdoor recapitalization method that is unavailable to the Fed when short rates are zero and long rates are pinned down by recession tamping down on expectations for future rate increases. This rationale is controversial because it has dubious economic value. But it is most certainly a factor in the backs of minds at the Fed.
I should also mention that yesterday, Fed vice chair Stanley Fischer was at the conference to hear Yellen’s remarks, as was former Kansas City Fed President Tom Hoenig. My sense is that they were comfortable with the remarks by Yellen and George respectively.
In sum, Q1 was a disaster for GDP growth economically. Some of this was weather-related but some of it was certainly non-weather weakness. Meanwhile, the Federal Reserve is concerned that with U-3 unemployment measures approaching its 5.2% threshold that a trigger by 5.0% is arriving quickly. Jobless claims well below 300,000 even in the data released today suggest this is coming. And the Fed wants to get out in front of inflation when unemployment reaches this target range. To the degree that the macro backdrop is benign in Q2, any other developments that suggest a lessening of dollar strength or signs of financial instability will only reinforce a tightening bias at the Fed. We should see Yellen’s comments and the sell-off in German bunds in this context. The only question now is what the macro data for Q2 look like.