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Yellen: The FED Will Make a Mistake

By - - Macro on May 26, 2015 10:21 AM Follow-Ups BKInitial

Yellen: The FED Will Make a Mistake

While Janet Yellen did not say those exact words she did imply that the FED will push on with monetary tightening despite having no ability to predict the future.

This reminds BK of a quote from Yogi Berra:

“It’s tough to make predictions, especially about the future”

Janet Yellen:

I am describing the outlook that I see as most likely, but based on many years of making economic projections, I can assure you that any specific projection I write down will turn out to be wrong, perhaps markedly so.

This quote is from Yellen’s speech on Friday, which many are crediting as the reason for the strength in the dollar over the last 72 hours. BK is heartened that Yellen acknowledges the limitations of economic forecasting and the inherent uncertainty that it imparts on monetary policy.  Her predecessor appears to have fully embraced the hubris of the “hero” moniker, and as such, a move toward humility is welcomed.

Fortunately for investors, Yellen suggested that a lack of clarity will not stop the Fed.  To BK, this line from the speech is a gift to macro investors:

Given this economic outlook and the attendant uncertainty, how is monetary policy likely to evolve over the next few years? Because of the substantial lags in the effects of monetary policy on the economy, we must make policy in a forward-looking manner.

Almost by definition, Yellen is telling investors that the FED will likely make a mistake…and therein lies the opportunity. Policy makers almost always underestimate the power of the feedback loop between markets and the economy.  For example, the rise in the US Dollar was due to markets anticipating policy divergence between the US and Europe – however the move was more pronounced than most people expected. This in turn lead to a de facto tightening in the US and the economy stalled. BK does not buy the ‘weather’ excuse, as the weakness has continued into Q2.

Since markets move faster and larger than policy makers expect, there is an opportunity for investors to bet on central banker errors.  This is exactly what BK expects to be doing for the foreseeable future.

US Dollar: The Trade That Pays

Yellen left the door open to a 2015 rate hike which will support the US dollar – therefore being long of US Dollar should be the trade that pays.  While the FED has officially done away with calendar guidance BK would argue that it has implicit calendar guidance.  That is to say that the longer the economy remains in its current state the more likely the FED is to raise rates so that it avoids overheating the economy.

Sidenote: The chances of the US economy overheating is about as likely as BK being able to dunk a basketball again.

The Next  6 Months

Now BK will also ignore Yogi Berra and attempt to make his own prediction about the future. As the US Dollar strengthens market forces (ie unwinding of the global carry trade) it will exacerbate and accelerate the move… which will feedback as another de facto tightening for the US economy. If this move in the US Dollar stops at 105 on the DXY it would make for a very nice little convergence of technical resistance and economic weakness. If past is prelude, we might expect dollar strength to continue into year-end as the FED continues to threaten a rate hike.

While BK feels he could write something about the prospects for 2016, he also recognizes that he is already pushing his luck by trying to make a 6 month prediction about the future.

Soooo..,What Does BK Do Now? (aka WWBKD?)

Stay long of US dollar – it’s the most obvious trade. –> BK short Euro and Yen

One can remain long of global equities BUT only if the currency impact is hedged i.e. DXGE and DXJ

US Equities remain a no touch for BK as the ONLY reason to be long is FOMO.

0 Follow-Ups

Peter: Yellen speaks but says nothing new

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Oil, Dollar, Bonds and Equities. Oh My.

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This is Part 2 of a 3 part Debate on Macro