Equity markets cheer dovish Yellen; Dollar falls

Equity investors across the globe welcomed Chair of the Federal Reserve, Janet Yellen’s testimony with open arms.

The Dow Jones Industrial Average jumped 123 points on Wednesday – a record high. The S&P 500 and Nasdaq Composite rallied 0.7% and 1.1% respectively. Meanwhile, the positive sentiment spread into Asian stocks, with all major indices surging across the board.

Although Yellen did not diverge from her statement at the most recent FOMC meeting by remaining committed to raising rates and reducing the Fed’s balance sheet as the U.S. economy continues to grow, she was apparently worried about the inflation outlook.

U.S. monetary policy makers have been trying to convince the markets that the incline in inflation is temporary. However, Yellen’s statement that “the Fed stands ready to adjust policy if it appears the inflation undershoot appears consistent” suggests that September rate hikes might be off the table for now and rates will not go much higher in the longer run.

The uncertainty about the course of inflation and the less hawkish tone from the Fed’s Chair sent yields on long-term bonds lower, which dragged the dollar index down. The combination of low yields, a weak dollar and untightened financial conditions is welcomed by equity investors, thus expect to see a continuation of the equities rally, especially if earnings season does not disappoint. 

 Currency traders will need to watch today’s U.S. PPI and tomorrow’s CPI figures very carefully. Inflation data will likely be the dominant influence on the dollar’s direction, and if prices do not show signs of strength, we are likely to see new lows on the greenback.

The most recent shift in statements from the central banks were translated yesterday, with Bank of Canada raising rates for the first time in nearly seven years. Markets are trying to figure out who is next in line to remove the extreme accommodative policies. Will it be Bank of England, European Central Bank, Sweden’s Riksbank or Norges Bank? The bottom line here is central banks are no longer diverging from the Fed, and albeit on different trajectories, it seems a coordinated move towards tighter policies, which is likely to narrow the spreads in fixed income markets and keep the dollar under pressure.