What to Expect from Janet Yellen

In welcoming Janet Yellen as the Federal Reserve’s new Chair come January 2014, one wonders whether to offer congratulations or condolences. She is about to take the helm of a battered ship heavily laden with liabilities, navigating a very narrow fiord with little wiggle room from the rocky shoreline on either side.

What precisely is she facing? What decisions is she likely to make? And what effect may those have on the markets?

Yellen’s Inheritance

Yellen will soon be entrusted with steering the U.S. Federal Reserve toward “fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates,” as outlined in its Statement on Longer-Run Goals and Monetary Policy Strategy.

To lower unemployment, stabilize consumer prices, and keep long term interest rates moderate, the Fed mainly turns to one thing… the U.S. dollar.

The rule is simple: To slow down an overheating economy, you strengthen the dollar, which makes it more expensive and less available, thus slowing down commerce. Conversely, to speed up a sluggish economy, you need to weaken the dollar, which makes it cheaper and more abundant, thereby greasing the gears of the economy.

This latter plan has been the Federal Reserve’s objective these five years since the financial and housing crises of 2008-09 – to weaken the U.S. dollar, making it cheaper to obtain for businesses and home owners. How? By lowering its benchmark interest rate.

As depicted in the graph below, the Fed has regularly lowered the benchmark rate in periods of slowing economic activity. But none has been as profound nor as long as the lowering since the 2008-09 financial crisis, with rates remaining at 0.25% for some five years now.

Source: TradingEconomics.com

But despite near zero rates, the economy still wouldn’t pick up and unemployment still wouldn’t fall. Since it couldn’t lower interest rates any further, the Fed made the dollar cheaper by pumping money into the economy through direct bailouts and purchases of bonds and mortgage securities.

In so doing, however, the Federal Reserve has laden itself down with enormous liabilities.

Source: Federal Reserve Bank of St. Louis

Where the Federal Reserve had less than $800 million worth of U.S. Treasuries and no mortgage-backed securities prior to the crisis, it currently carries over $2 trillion worth of Treasuries and $1.3 trillion worth of mortgages on its balance sheet, a gain of over $2.5 trillion of liabilities – which is still growing at a rate of $85 billion a month, or $1.02 trillion a year.

Has this worked? To a certain extent. But only until the injections wore off.

Source: BigCharts.com

As noted in the graph above, the U.S. Dollar Index (DXY) strengthened considerably at the height of the crisis in the second half of 2008 (red) in a typical flight to safety when everything else was being dumped.

When lowering interest rates didn’t succeed in bringing the dollar down, the Fed introduced QE 1 (green), which did the job… for a while. When that dose of liquidity wore off and the dollar strengthened again, the Fed applied QE 2 (blue), which again did the job… for a while.

The most recent Fed attempt to keep the dollar down and mortgage rates low came in September of 2012 (orange), the monthly recurring purchasing of $85 billion worth of Treasuries and mortgage securities we know as QE Infinity.

Yellen’s Challenges

Janet Yellen’s task, then, is to finish the job that the Fed has been working on for five years, namely to get unemployment down below 6.5% and inflation back up to 2-2.5%. But she has two major challenges:

• First – the U.S. dollar is still too strong and the economy is still too weak to reach those targets without continued stimulus.

• Second – the longer stimulus is continued, the more distorted the stock and bond markets will become, the larger the Fed’s balance sheet will grow, and the more painful the road back to normalcy will be.

Remember, at some point all that money the Fed has pumped into the economy is going to have to come back out. And interest rates will have to return to their normal levels, which the first graph shows to be around 5 to 6%.

This is the monster that Yellen must slay – the unwinding of Federal policy back to the norm, without stalling the economic recovery in the process. No other Federal Reserve Chair has ever had to face this kind of monster before. This appointment will likely be the defining task of Yellen’s career.

But we needn’t worry. She has an impressive list of credentials that make her more than qualified to steer this ship to port.

Ms. Janet L. Yellen

Dr. Yellen obtained her economics degree at Brown University in 1967 and her economics doctorate at Yale University in 1971. After serving 5 years as Assistant Professor at Harvard University from 1971-76, Dr. Yellen began her first post at the Federal Reserve as an economist to the Fed’s Board of Governors in 1977-78.

After teaching at the London School of Economics and Berkeley UCLA, Yellen returned to the Federal Reserve as a member of the Fed’s Board of Governors from 1994-97, then as President and CEO of the Federal Reserve Bank of San Francisco, and since 2010, she has served as Board of Governors Vice Chair alongside Chairman Bernanke.

Her specialty? “Dr. Yellen has written on a wide variety of macroeconomic issues, while specializing in the causes, mechanisms, and implications of unemployment,” her Federal Reserve profile reads. With unemployment as one the Fed’s primary mandates, she certainly has the right background.

Yellen’s Likely Course

Viewed just as dovish as the current Fed Chairman Bernanke, economists expect Yellen will stay the course currently in place, with a focus on low interest rates for a cheaper dollar and continued downward pressure on mortgage rates.

At her nomination press conference Wednesday, Yellen mentioned a “strong and stable financial system” as another goal she will undertake. Since the Dodd-Frank Act was passed in 2010, the Fed has played a major role in helping banks increase capital and liquidity standards, that they may better deal with crises without needing taxpayer relief. Look for Yellen to keep that focus.

“She’s participated in those discussions, she’s voted for them, so I can’t see any major changes,” Ernie Patrikis, former counsel at the New York Fed, informed Bloomberg.

“This means all engines forward as Dodd-Frank continues to get implemented, just as if Bernanke was still chairman,” added Jaret Seiberg, a senior policy analyst with Guggenheim Securities LLC’s Washington Research Group.

But her past management style shows that Yellen will stand out “not in toughness on systemic risk,” but in that “she will look to see what the financial consequences of a rule are, or will it have adverse effects from an economic-development perspective,” Karen Shaw Petrou, managing partner at research firm Federal Financial Analytics Inc., revealed to Bloomberg.

Another difference we are likely to see is an improvement in the Fed’s communication strategies and procedures, which have been criticized recently for being unclear and too infrequent. We should expect more direction from the Fed regarding its thinking, especially concerning any stimulus tapering.

With less than four months remaining before the leadership change, the task of reducing the monthly bond purchasing plan will be hers. But the recent disruptions caused by the government shutdown and continuing sequester may have tied her hands. The economy may not be ready for stimulus reduction until well into 2014.

If the markets enjoyed Bernanke’s run at the helm, they should be quite happy with Yellen’s. The Fed’s easy-money policies of the past five years will likely remain in play for several years more.

Just be ready for some jolts along the way, two in particular – once when bond tapering begins, likely in early 2014, and again when interest rates start rising, not likely until after 2015, perhaps as late as 2017.

There are a lot of purchases on the Fed’s balance sheet which must be unwound. And it will not be easy to do, as taking money out too quickly will slow the economy down. But Yellen is smart enough to wait until the economy is strong enough to handle it before she begins the extraction process.

The best way to prepare is to pay attention to FOMC announcements, and of course, “Don’t fight the Fed.” Remain long equities, preferably medium and large caps; opt for variable rate bond funds over fixed rate funds; and use margin conservatively, if even at all.

And expect continued downward pressure on the USD for a few more years, which should help the precious metals. Gold and silver may still have a few good years left.

Joseph Cafariello

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