Tomorrow begins the semi-annual testimony of the Fed chair before the illustrious houses of legislature of the United States. Janet Yellen will testify before the House Financial Services Committee tomorrow and the Senate Banking Committee Thursday. Chair Yellen will read the same prepared speech before each Committee and then each member of the Committee gets a preset allotted time to ask questions. (Please note, Yellen’s testimony will be released at 7:30am CST tomorrow.) The chair will dodge predictions but will put forward the most recent DOT PLOTS and FOMC statement as the backdrop to her testimony. THE MOST INTERESTING ASPECT WILL BE WHETHER OR NOT THE FED CHAIR SOFTLY CRITICIZES CONGRESS FOR NOT DOING MORE TO PUT FORWARD SOME TYPE OF FISCAL STIMULUS. Chuck Schumer may believe the FED is the only game in town but Chair Yellen will plead that the FOMC cannot be the sole stimulant to a moribund economy, especially with the headwinds blowing around the globe.
The FED will be under attack from the political left for raising interest rates even though wages have remained stagnant. The political right will ask about why the FOMC waited so long before removing the ZIRP. Also, pay close attention to Yellen’s answer to the inevitable question about the economy going to a NIRP (negative rate policy). The Fed chair will say that the employment growth has been strong and the recent unemployment rate of 4.9% is pushing against the non-accelerating inflation rate of unemployment (NAIRU), an indication that the theoretical closing of the OUTPUT GAP hints at a coming rise in wages and thus possible inflation pressure. My question about NAIRU: Is a domestic employment gap relevant to upward wage pressure when a billion Indians are beginning to join the global labor force? (Hence the NEHRU pun.)
The Chinese economic miracle unleashed a billion potential workers and put downward pressure on wages across the globe. With the INDIAN RUPEE trading at multi-decade lows, foreign direct investment will begin to push competitive Indian goods around the globe. The FED keeps its models on a domestic bias but as long as labor and capital flow are unimpeded around the world the influence of labor thresholds is severely diminished. Coupled with the flawed NAIRU measure, January’s Labor Market Conditions Index revealed some new softness in the 10 labor market indicators that Chair Yellen relies upon for a full picture analysis.
The current fragile financial situation around the globe, plus an uncertain wage situation in the U.S. will tilt Yellen toward the dovish side. She will not be in Stanley Fischer’s ballpark of four rate increases, but will play in a LEAGUE OF HER OWN. Again, Chair Yellen’s background is as an academic labor economist who has shown great concern for the stagnant wages of the middle class. The power of the NEHRU is greater than the academic theory of NAIRU.
***Yesterday, there was an article on Bloomberg’s First Word platform titled, “Yield Curves Don’t Have to Invert to Signal Recession,” in which the writer, Alexandra Harris, quotes BofA’s Ruslan Bikbov as theorizing that in a near-zero interest regime, the yield curve doesn’t need “… to flatten significantly for a recession to occur.” Bikbov is making a point that I have raised in the BLOG and with Rick Santelli many times. The FED and the central banks have broken the signaling mechanism of global bond markets, which is why volatility will increase as investors do not have a reliable tool in which to price risk. This was a great concern of FOMC member Jeremy Stein, who resigned from the FED and went back to teach at Harvard because he couldn’t prevail on this critical issue (my opinion). But I have noted that the yield curve still has importance as critical price levels are violated. All hell will break loose when we close under 115 basis points on the 2/10 curve.
Well the exaggeration was intentional as the renewed flattening in the curve has created greater market uncertainty and probably increased angst in the FOMC boardroom while the yield on the 10-YEAR TREASURY NOTE has declined more than 40 basis points since the December 16 rate increase. Yes, the 10-year note is responding to the global drop in yields, which should be very disconcerting to a domestic-oriented FED. Negative yields around the world are having a detrimental impact on the designs of the FED models. Today, the 2/10 curve settled at a an eight-year low and is closing in on 95.53 basis points last touched on January 2008.
The big difference from eight years ago was that the FED FUNDS RATE was at 4.25%, which gave the FED room to cut rates in response to signals provided by the yield curve. Today, the FED has very limited capacity to respond to a flattening yield curve. The lack of steepness in the YIELD CURVE is acting as a drag on bank profits, which raises the question about the FED removing the Interest on Excess Reserves (IOER), a profit center for the large banks. If the FED went to negative yields and if the curve did not react via steepening, bank profits would be squeezed.
***More duress in Europe as yields on Greek two-year notes climb to 15.5% as not all is going well in the Greek negotiations. It appears that the market is pricing in the Greeks departing from the EU and a Greek debt default. The Portuguese sovereign yields are also on the rise as the 10-year note approached 3.75%. All is not well in the European debt markets, but because of the ECB‘s active intervention the market is not able to price sovereign bonds accordingly. If the BIS were to ever push for a realistic risk weighting for sovereign debt many more European banks would be severely undercapitalized for bank regulations deem all sovereign debt to carry a zero risk weighting, which means there is no capital reserve required. This will continue to be on our radar. Maybe Chair Yellen will actually be asked about the stress and strains in the European capital markets and their impact on the U.S. financial system.