The "Yellen FED"

We had known for quite a while that Federal Reserve Chair Janet Yellen was ranked in the dovish camp. During her most recent appearances after the last FOMC on March 16^th and the speech on March 29^th in New York, she explained why there was currently an asymmetry in the central bank’s reaction function regarding incoming data and what to look out for. 

In order to achieve its dual mandate, the “Yellen Fed” is data-dependent, but well beyond US employment and inflation data (see below). Indeed, much emphasis is put on international parameters such as global economic and financial developments, including commodity prices (particularly oil), interest rates and stock values. Further, developments in China are singled out, as the economic transition is having a significant influence on global growth. More domestically, Chair Yellen is keen to see the housing sector make a larger contribution to US growth going forward as the pace of household formation has not kept up with population and income growth and, accordingly, has depressed homebuilding.

Financial markets are digesting the increasingly clear definition of the current setup of the Federal Reserve’s reaction function: as long as the federal funds rate is close to the zero boundary, it will systematically be tilted against downside (weak growth / low inflation) risk. As a result, the probability of the next Fed Funds hike happening in June has fallen from more than 40% the day before the March FOMC to 17% today, leading to a 25bp decline in the 10y US bond yield. During the same period, the US dollar index has weakened by more than 2%, allowing US stock markets to rise by approx. the same amount.

In terms of asset allocation, the Fed’s message is in line with our expectations of a gradual pick-up in inflation expectations, better economic performance in emerging markets thanks to the end of the US dollar appreciation and, ultimately, a bottom in commodity prices at the start of the year. On the inflation front, Chair Yellen reminded us that the 2% figure is a target but not a ceiling, signalling her readiness to be behind the curve on this issue as price inflation can be fought easier than deflationary pressures. More broadly, it makes us confident of a constructive scenario with attractive expected returns in risk assets as there is little risk that the Fed will kill the expansion by tightening too fast, too far.

The Yellen Fed Checklist

Source: Candriam Asset Allocation Strategy