There is nothing in Yellen's speech to be labelled as 'dovish', unless deflation is set to worsen

Outlook:

When the written Yellen speech was released, we immediately thought she was affirming the June rate hike, given the usual conditions—inflation has to be seen to be on the rise. We can expect a change in forward guidance at the next meeting, i.e., the removal of the word “patient”—although that may mean a hike after two more meetings or it may not. This is not exact-ly hawkish except as an affirmation of what key members have been saying for several weeks now—June is a reasonable expectation. Don’t get gung-ho, because we need more data, but the expectation is correct.

We thought we saw the euro/dollar respond appropriately, from 1.1340 ahead of the release to 1.1287 in the first half hour after it. But all was not right with the world. By noon the euro was rising again and it proceeded to a high of 1.1390 by the end of the Asian session, or about 100 points. The market saw Yellen’s comments as dovish and not hawkish, after all. This is strange and surprising, since the tone is carefully neutral and there isn’t anything outright dovish in there, hard as you may look. Cautious, yet, but not dovish.

In other words, the market is wrong. The old saw has it that the market is never wrong, meaning if you fight market sentiment, you will lose your shirt. But that’s trading advice, not a comment on the excel-lence of market analysis. In practice, the market is wrong quite often. Look at the CAD. Traders had priced in another rate cut at the March 4 meeting. Then BoE Gov Poloz seemed to say “probably not”—the Jan hike was just an insurance policy, not the start of a trend. So the traders were wrong to price in a rate cut, especially in the context of confusing oil and commodity price moves.

We are therefore cheered to see the Wall Street Journal lead story this morning headlined “Janet Yellen puts Fed on path to lift rates.” That’s more like it. WSJ reporter Hilsenrath, writing without a co-author this time, is annoyingly self-important but he does have good connections at the Fed. His interpre-tation will carry weight. Similarly, the FT headline reads “markets play chicken with the Fed over rates.” The FT quotes Deutsche Bank’s Ruskin: “Once you enter a tightening phase, flexibility becomes important. The door to a hike in June is open, even if she [Yellen] has not shown she plans to walk through it.”

The key paragraph in Yellen’s written speech says "If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings."

We find the language cumbersome and awkward, if not rising to the irritating level of Greenspan’s fa-mous obfuscation. First, we have decent growth and good employment, so that last data that needs to fall in line is inflation. We are still a little worried about deflation but as soon as we feel sure inflation is headed back to 2%, we will act. Why can’t the Fed just come right out and say that? Equally awkward is the message on changing forward guidance, aka “patient.” Removing the word, presumably in March, does not mean the rate goes up in a couple of meeting. And yet that’s exactly how Yellen defined re-moving the word patient at the Jan FOMC press conference. So, instead of the ornate and unclear, Yellen could have said “We plan to change the forward guidance in March but I’m taking back the inter-pretation that it means a rate hike in June.” See point 1—we need some inflation first

Cool heads, and there are some, continue to think the Fed plans the first hike in June and will conduct the first hike in June unless inflation data is so discouraging that it can’t. There is nothing in Yellen’s speech to be labelled dovish, unless your crystal ball shows you that deflation will worsen and the Fed cannot act. So now the question becomes when does the FX market wake up to its “mistake”?

Unfortunately, tomorrow’s inflation report will probably not do the trick. Yellen has emphasized that the oil-driven inflation numbers are a temporary aberration, but try telling that to trigger-happy traders who didn’t live through 1979-1980 Volcker years. (We were trading Fed funds futures at the time and re-member falling out of the chair at 22% for overnight money.)

The market can stay irrational longer than you can stay solvent, said Keynes, so we need to borrow the word patient from the Fed. They will get the point eventually. Bottom line, the dollar rally ain’t over yet, especially with the ECB QE starting up in March. March is next week, thank goodness. Ahead of QE, European yields are sinking again. The FT notes Irish 10-years at under 1% for the first time ever and Germany auctioned a 5-year note at a negative yield for the first time. Again, yield differentials are not the sole or even the most important factor determining exchange rates, but they are not trivial, either.

At some point the penny will drop that everybody is cutting returns while the US is offering them. How can the dollar lose? Well, the dollar can lose if other factors are powerful enough to weigh down the dif-ferential—stupid things like threats of default or even over-interpreting inflation data. We don’t have them yet but they lurk in the shrubbery. Still, we think the euro is toast, especially because Greece is already whining about not being able to pay its debts. We need a trigger, but we still have levels near the previous low 1.1100 in our crosshairs—that was only at the end of January (Jan 25).