Summers, the taper and Syria

Introduction

Recently, we set out the outlook for interest rates in a piece entitled, “Interest rate and bond yield outlook given global economies and expectations” on 28 August. Among other things, we argued that the financial markets had adopted a somewhat optimistic expectation of growth and interest rates, leading into the US Federal Open Markets Committee (FOMC) decision. As we now are very close to the announcement, the retirement of Larry Summers from the race to be the next Federal Reserve Chairman is discussed, along with our expectation for the FOMC decision and commentary, and a short comment on the Syrian situation. Accordingly, the enclosed piece will discuss the following:

• Why the Summers nomination was important to the FOMC debate,
• the forthcoming FOMC decision, and
• the Syrian conflict.

1          Summers and the Empathetic Yellen

Media coverage of the possible appointment of Larry Summers, as a possible Federal Reserve Chairman, has been intense. One of the reasons, among others, that this debate was important to financial markets, was that the appointment of Summers was seen as a way for the market to argue that the optimistic views on growth and rates were valid. This is because Summers was believed to have indicated a hawkish view on monetary policy; much in line with the financial markets. However, Summers recently declined any possible nomination, since Democrat senators viewed Summers as one of the people who allowed financial market de-regulation to proceed; someone who effectively engineered the global financial crisis (GFC).

Markets reacted immediately with the Australian Government 10 year bond yield falling 16bp between close on Friday (4.09% YTM) and where it opened on Monday (3.93% YTM), following Summers withdrawal from the race. However, the market gave up a lot of those gains, since it has since traded back to 4.05% late on Tuesday.  

Now, the market is viewing the appointment of Janet Yellen, as something that may well challenge the prevailing optimism, and the idea that the Federal Reserve is just about to start raising short term interest rates. Yellen has an enviable record of betting against an overly optimistic group of market forecasters, and getting it right, as the Wall Street Journal has documented in a recent article entitled, “Federal Reserve 'Doves' Beat 'Hawks' in Economic Prognosticating Slow Growth, Low Inflation Give Yellen, Dudley Upper Hand on Forecasts”, by Jon Hilsenrath and Kristina Peterson, on July 28. What Yellen has done, more than most others at the FOMC, is to fully appreciate the size and scope of the current recession and that the recovery has been slower than it should have been, being held back by the following factors:

• fiscal contraction,
• slower housing contributions to growth compared to past recoveries,
• a collapse in expectations for future income growth, and
• the European crisis and recession.

These factors, among others, have led a situation where cyclical unemployment plagues expectations, and has led to broad measures of unemployment being a source of continual disappointment. It is here, in her assessment of the impact of unemployment, where Yellen really comes into her own demonstrating an empathy with the unemployed that is rarely displayed by officials. Such empathy is clearly displayed in the following passage from a recent Yellen speech, where Yellen is commenting on some unemployment related data,

These are not just statistics to me. We know that long-term unemployment is devastating to workers and their families. Longer spells of unemployment raise the risk of homelessness and have been a factor contributing to the foreclosure crisis. When you’re unemployed for six months or a year, it is hard to qualify for a lease, so even the option of relocating to find a job is often off the table. The toll is simply terrible on the mental and physical health of workers, on their marriages, and on their children

(Source: “A Painfully Slow Recovery for America’s Workers: Causes, Implications, and the Federal Reserve’s Response”, Remarks by Janet L. Yellen, Vice Chair, Board of Governors of the Federal Reserve System, at “A Trans-Atlantic Agenda for Shared Prosperity” A Conference Sponsored by the AFL-CIO, Friedrich Ebert Stiftung, and the IMK Macroeconomic Policy Institute, Washington, D.C., February 11, 2013, p.10)

We believe that it not only the recent forecasting ability of Yellen that is of interest, but this type of empathy with the unemployed, which stands Yellen in good stead for the Chairperson of the Federal Reserve position. At this time, the Federal Reserve needs a connection to the problem that will continue to be important to the FOMC; the massive problem unemployment. While Yellen is the current frontrunner, some have argued that Donald Kohn is well placed, as Yellen might be seen as excessively dovish, especially from the Republican point of view.

2          FOMC decision

It appears that the FOMC have become aware that quantitative easing (QE) can influence asset prices, and that aligning expectations to the fact that it can be withdrawn, and is not permanent, is now required. What the market has done, however, is to add an inveterate level of optimism to this alignment. Hence, the market has talked itself into the idea that a small reduction in QE, or a “tapering” of QE, will then lead to an almost immediate rise in short term interest rates. In other words, the recent rise in long term rates is all about the market, and the way it takes an optimistic view, rather than what the FOMC is doing, or is about to do. Now, it could be suggested that recent US data has underperformed and that may lead the FOMC to “taper” expectations of growth, of employment growth and of inflation, rather than QE. It will be these expectations, or these forecasts, which represent the most interesting aspect of the forthcoming FOMC announcement. Here the following comments can be made:

• Growth: it is likely that the growth forecast for 2013 will be brought down somewhat as it seems unattainable, yet there may be some increase in the 2014 forecast,
• Unemployment: again, estimates provided in June look a tad optimistic and the unemployment estimates may be revised up, slightly, and
• Inflation: this estimate always seemed optimistic to us and without much basis, while the recent PPI and CPI data point to the difficulty in attaining the estimate. Hence, some downward revision in this expectation may well be in order.

3          Syria conflict

Financial markets have put the Syria issue behind it as a result of the recent agreement between the US and Russia. However, the scale of the Syrian conflict is immense, as the following estimates indicate:

• UN estimate of deaths (June 2013)  around 83-100k, and
• Over 2m refugees (September 2013 UNHCR estimate).

With around 10% of total population now refugees and various estimates of internal displacement at around 10% of the total population, the statistics speak for themselves. While some have likened the conflict to that of Libya, the proximity of Syria to Israel makes the conflict much more difficult to forecast and make predictions about. Specifically, there are concerns that Syria, if struck by US military forces, will respond by using chemical weapons against Israel and that Iran will also launch strikes against Israel when the US intervene, as well as Hezbollah in southern Lebanon. In other words, the Syrian conflict is not only large by any measure, it is something that can draw Israel into an all-out military confrontation. In other words, one needs to remain vigilant regarding the possible impact of Syria on the pricing of financial markets.

Conclusion

In some ways the struggle for the chairmanship of the Federal Reserve has become one of tussle between arrogance, as expressed by Summers, as opposed to empathy, as expressed by Yellen. In this case, empathy may have won the day and the US economy should be the healthier for a possibly more accommodative FOMC Chairperson, with yields falling in expectation. While the market has become obsessed about the proposed “tapering” of QE, the real issue remains what the FOMC will do with regard to tightening of monetary policy and the forecasts of the FOMC will be crucial in that respect, when they are released on Thursday morning. Regardless of the outcome of the FOMC meeting, the Syrian conflict will remain of importance to financial markets, with the potential to dramatically disrupt oil production in the region, thereby lifting oil prices dramatically.