Yellen argues complacency in the market is not a problem

Outlook

The main release today is weekly jobless claims, leaving plenty of time to ruminate about central banks. The Fed let us down, although we can’t complain about transparency. Tapering will end in October if the economy doesn’t surprise on the downside (this means an extra $5 billion in Oct). Reinvestment of QE income, while still debatable, will likely continue up to the last minute or even beyond the first rate hike. Many members ex-pressed a preference for a Fed funds range instead of a single number. Unemployment is still unsatisfactory on the quali-ty count and wages lag, harming household spending. And oh, yes, low volatility in every market and high risk-taking indicate investors are “not factoring in sufficient uncertainty about the path of the economy and monetary policy." Well, whose fault is that?

In the FT today, fund manager Merk has an opinion piece that starts “Alan Greenspan suggested home prices could not fall; Ben Bernanke suggested the subprime mortgage market problems were contained; and Janet Yellen argues compla-cency in the market is not a problem. The current Federal Reserve chair, just like her predecessors, might well live to regret those words.” No one knows when, but low volatility/complacency can’t last forever. A crash is coming, or at least a fat correction, chiefly because traders and investors are dumb. Mark is only the latest in a long line of doomsters, but we say he has it right because he is focusing on crowd psychology and not some economic ideology.

St. Louis Fed Pres Bullard is the first of the Fed officials to speak out about the outlook, and we always like the St. Louis Fed, famous for its no-BS research (unlike some other regional Feds that toy in the field of worthless economic model-ling). Bullard admits he is the “North Pole” of hawkishness but he is also the most influential of the regional Feds. Bullard gave a no-punches-pulled interview to Bloomberg, saying the US will overshoot on inflation and get 2.4% by end-2015, over the Fed target—hardly the slow convergence the FOMC is promoting. Unemployment under 6% (it’s 6.1% now) is a hard rule for inflation.

Bloomberg reports the killer comment: “Bullard said investors are underestimating the level of Fed tightening for 2015 and 2016 by ignoring the forecasts of FOMC participants. Their median projections, released in June, call for a target interest of 1.13 percent at the end of 2015 and 2.5 percent a year later. ‘It is a mistake for the market not to go with the median of the committee. I think that’s the best indication we have.’” Bullard doesn’t see anything to panic over in bubbly markets, but rates persistently too low feed a “bubble process.”

Separately, the apparent failure of a Spanish bank is so far driving European equities down and peripheral yields up. We don’t know whether this will turn into a crisis, but it sure puts a big black mark on the steady-as-she-goes attitude of the ECB toward asset quality and stress test reviews. The ECB is due to take over pan-EMU bank regulation in November, and clearly not a minute too soon. We expect a rescue operation, not a series of falling dominoes.

Alone among the press is the New York Times to signal out a comment yesterday by Mr. Draghi, who said “There is a case for some form of common governance over structural reforms. This is because the outcome of structural reforms — a continuously high level of productivity and competitiveness — is not merely in a country’s own interest. It is in the interest of the union as a whole.”

Draghi pointed out that the WEO ranks Finland third in competitiveness while Greece comes in at 91. “The persistence of such differences creates the risk of permanent imbalances,” Mr. Draghi said. He doesn’t say how this would be set up and implemented—maybe a supranational body.
Oh, dear. This sounds like the nanny state on steroids. One of the strengths of the federal system is variety, which is why we have California and also Mississippi. There’s probably nothing much here but global investors who blindly favor the euro at all times and whatever the current conditions might want to reconsider. Draghi is trying to get rid of state interference, like the state-accepted stranglehold of unions (inability to fire workers), already getting some results in Spain and Greece, but to do it with state actions is surely counter-productive.

We like the idea of a falling euro for economic and institutional reasons, but after so many years of seeing conditions that “should” favor the dollar and do not, it’s hard to shed our perma-bear coat. The Fed’s lower for longer is—so far—a good reason to stay bundled up.