The Rationale Behind Yellen’s Mixed Message

Yellen Continues Down Familiar Path Of Confusion

Last week Janet Yellen spooked the markets by hinting an interest rate hike may be coming sooner than many market participants were expecting. Monday, the Fed Chairwoman highlighted the need for a dovish stance on rates. If you follow the markets closely, you have probably asked yourself at some point why does the Fed keep sending mixed messages? If we think in extremes, we can understand the Fed’s rationale. Let’s assume the Fed released either of the following statements:

Statement A: We have no plans in the foreseeable future to raise interest rates.

Statement B: We will begin an aggressive campaign to raise interest rates effective immediately.

Statement A could fuel inflation expectations and encourage bubble-like behavior in the stock market. Statement B could spark a sharp and pronounced plunge in stock and bond prices. The Fed does not want to see either outcome. Therefore, they try to forge a balance between statement A and statement B.

Fed In Full Mixed-Message Mode

Last week’s hawkish comments on interest rates spooked the stock market. Monday’s dovish comments helped push stock prices higher. From The Wall Street Journal:

Federal Reserve Chairwoman Janet Yellen said Monday the U.S. economy and job market are still far from healthy, and still require plenty of support from the central bank’s low-interest-rate policy. Ms. Yellen “seized the first opportunity to downplay her comment that a ‘considerable period’ after the end of [the Fed’s bond-buying program] implied just six months before raising rates,” said Bricklin Dwyer, an analyst at BNP Paribas. “Yellen pulled out just about every dovish tool in the box as she highlighted that the economy needs extraordinary support for ’some time.’ “

A Dead Heat: Greed vs. Fear

With somewhat ho-hum economic data and mixed signals from the Fed, investors have been unwilling to make big bets on stocks or bonds. Common sense tells us that when stocks outperform bonds, investor greed is greater than investor fear. Conversely, when investor fear is greater than investor greed, stocks tend to drop relative to bonds. When investors are hesitant and uncertain, there is no clear winner in the race between stocks and bonds. As shown in the chart below, investors have been hesitant and uncertain since late December 2013, which is indicative of a more vulnerable stock market.

Deflation Fears In Europe

As we have outlined in the past, central banks have limited weapons to fight a deflationary battle, and thus, are fearful of letting economies slip into a deflationary spiral. Monday’s inflation reading in Europe was not what the European Central Bank was hoping for. From Bloomberg:

Euro-area inflation slowed in March by more than economists forecast to the lowest level in over four years, keeping pressure on the European Central Bank to take action to foster the currency bloc’s recovery. Today’s result is half of the ECB’s forecast for 2014 and well below the central bank’s medium-term objective. ECB President Mario Draghi on March 25 renewed his vow to “take additional monetary policy measures” if “any downside risks” appear to its forecast for a “gradual closing of the output gap in the coming years.” These risks include subdued prices and a strengthening euro, he said.

Big Picture Shows Indecisiveness

You might think with the Fed pulling back and the ECB talking about stepping up that investors would be showing a clear bias toward European stocks. As shown in the chart below, that is not the case. The ratio of European stocks (FEZ) to U.S. stocks (SPY) has made no progress since early November 2013.

Investor indecisiveness is also alive and well back in the United States, as many risk-on vs. risk off indicators have been flattening out in recent months. When economic conviction is low and bullish trends are waning, it is always a good idea to take a step back and review the big picture, which is exactly what this week’s stock market video does.

Shifting To A Slack Approach

The Federal Reserve recently changed their guidance parameters to allow for a more flexible approach on the interest rate front. The ECB is attempting to increase flexibility as well. From Bloomberg:

Draghi mentioned slack for the first time last month to reassure investors that borrowing costs will stay low even as the economy revives, adopting a guidance tool employed by Bank of England Governor Mark Carney only three weeks previously. Unlike indicators such as the jobless rate, which the BOE previously cited as a key threshold, spare capacity is vague enough to give officials plenty of leeway in deciding when to exit ultra-loose monetary policy. It’s essentially a way for them to convey to market participants and the public that they don’t intend to tighten policy until the recovery has really got under way,” said Hetal Mehta, a London-based economist at Legal & General Investment Management, which oversees 450 billion pounds ($749 billion). “Slack is very difficult to measure, there’s no agreed way of pinning it down. But we can expect them to keep talking about it.”

Investment Implications - Patience Is A Virtue

With mixed messages from the Fed, economy, and markets, it is best to remain patient until a clearer picture develops. Our confidence in stocks would increase if the major indexes are able to post new highs, which for the S&P 500 means a push above 1,883. The economic bears would gain some leverage with an S&P 500 close below 1,844.

The Dow Jones Industrial Average was one of the few major indexes that was unable to print a new high in early March, which can be taken as a sign of economic vulnerability. Therefore, from a bullish conviction perspective, some patience is prudent as long as the Dow remains below 16,588.

Not much has changed in recent weeks. The big picture still favors stocks over bonds, but not in an overwhelming manner. Therefore we have offset our S&P 500 (SPY) and technology positions (QQQ) with a good size cash buffer. With an ISM manufacturing figure coming Tuesday and the monthly labor report Friday, it is possible conviction begins to surface in some corner of the investment universe.