Daily Comment (July 12, 2017)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] The Chair speaks: The text of Chair Yellen’s comments has been released in front of her testimony to Congress.  Market reaction is consistent with a dovish stance.  Here is the excerpt that is probably triggering the weaker dollar/stronger equities/stronger Treasuries/higher gold trade:

based on our view that the federal funds rate remains somewhat below its neutral level—that is, the level of the federal funds rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel. 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 to a neutral policy stance.

Essentially, Yellen is signaling that the path of rate hikes will probably be gradual; if we were allowed a question, it would be, “So how does this comment relate to the “dots” chart?”  We suspect that Yellen is signaling that she is at the lower end of the dots dispersion.  She also indicated that the reduction of the balance sheet will commence soon.

The balance sheet issue: We remain quite concerned about the balance sheet reduction.  Although the real impact of QE will be the subject of dissertations for the next decade, in our analysis, the primary effect was to bolster confidence.  In reality, the bulk of QE ended up on bank balance sheets as excess reserves.  Thus, removing these reserves shouldn’t have much of an effect, either.  However, given the unprecedented nature of this event, there is still the risk of unexpected outcomes.  We are noticing something interesting, though.  Yesterday, a five-star dove, Governor Brainard, said that she sees a “low cap” on interest rates but supports balance sheet reduction (similar to Yellen’s above quote).  It appears that there is near unanimity on the FOMC that reducing the balance sheet is a good idea and we suspect the doves are supporting this plan because it will divert the hawks from raising rates.  If it turns out that withdrawing QE is a non-event, the doves will win if the reduction slows the pace of rate hikes.

Cohn for Chair? Politico[1] has a long report suggesting Gary Cohn will likely be the next Fed Chair, replacing Yellen when her term expires in early February.  Cohn checks a number of boxes.  He is likely a moderate on policy, which will suit a “low interest rate” president.  Although the nationalists (Bannon, et al.) don’t really like Cohn and would like to see him back at Goldman Sachs (GS, 226.95), they would rather see him at the Fed than as chief of staff, another job he has been rumored to be heading toward.  He isn’t an academic economist, which is probably favored by a business president.  The hardline rules-based GOP members of Congress would not be all that pleased with a Cohn Chair, who has been a Democrat, but they would likely go along.  Although predicting a mercurial president is always tough, and reports suggest Trump isn’t focused on this issue yet, we do think this is probably Cohn’s job if he wants it.  And, if the administration is struggling (its political capital will be nearly depleted by Q1), exiting to the Fed might be a good career move.

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[1] http://www.politico.com/story/2017/07/11/trump-cohn-yellen-fed-240421