Janet Yellen – Her First Challenge in 2014

Posted by David Nelson, CFA on January 7, 2014 in Investment Management | Leave a comment

By David Nelson, CFA

Last night the Senate confirmed Janet Yellen as the next Fed Chairwoman. The confirmation was never in doubt but Fed watchers were all curious as to how large the margin would be. Many believed the no votes might be as high as 30, matching exiting Chairman Bernanke. With a vote of 50-26 Ms. Yellen will become the first woman to sit in that chair in the Fed’s 100 year history.

It’s important to remember that Ms. Yellen was not President Obama’s first choice. He first floated Larry Summers, former Treasury Secretary under Bill Clinton but that quickly met resistance from both sides of the aisle. Investors seemed concerned as well, believing he would remove Fed stimulus far quicker, maybe raising interest rates early in his term.

Ms. Yellen will be an extension of Mr. Bernanke’s vision having openly expressed support for the policies. I think we should take the Fed at their word. They’ve announced the rollback of QE to the tune of $10 Billion per month and said they will be data dependent. I expect them to follow that path and to eliminate quantitative easing by the end of 2014. Despite the rhetoric, I believe the Fed had come to the conclusion the program had run its course and was offering diminishing returns.

The Challenge

The challenge for Ms. Yellen in 2014 is managing expectations and the coming rise in interest rates. I think most investors are prepared for a 10 year headed to 3.5%. How quickly that occurs is an issue the Fed under her leadership will have to deal with. Problems for investors will likely show up in the bond markets first.

Fed Balance Sheet

The Fed operates under a dual mandate dealing with both inflation and employment. Despite a massive increase in the Fed’s balance sheet, the inflation investors feared didn’t materialize. If you look at the chart from the Federal Reserve you can see that toward the end of 2012 treasuries held by the Fed went parabolic. Interestingly, that coincides with an accelerated decline in gold prices. Gold is traditionally thought of as a hedge for inflation. I don’t think the hyperinflation many feared from Fed policy is on our doorstep. I fail to see how the argument gets stronger now that they are heading for the exits.

Energy prices and wages are key measures of inflation. With the United States following a path toward energy independence, I expect oil prices to remain stable. I’ve pointed out in previous posts and interviews that while I am bullish on both the markets and the economy, I don’t believe wage inflation is a natural outcome. To get wages rising I think we’ll have to approach full employment. Unemployment in the United States is as much a secular issue as it is cyclical. We’ve been exporting jobs for decades.

You Can’t Outsource Your Plumbing

While globalization reduces the costs of goods and services it also holds wage inflation in check. Until a good or service is the same here as it is in other industrial centers of the world it will be difficult for wages in aggregate to move meaningfully higher. Jobs go to where they are cheap and in most cases that simply is not here. If you want to work in a protected industry become a plumber. You can’t outsource your plumbing.

Consensus for Friday’s employment puts non-farm payrolls at 200k, on par with what we’ve seen the last couple of years. For wages to rise from current levels those numbers have to move significantly higher.

Bernanke’s Biggest Fear

It appears on this point Mr. Bernanke was right. As a student of the Great Depression his biggest fear during the onset of the financial crisis in 2008 was deflation. Determined not to make the same mistakes as his predecessors, he took rates close to zero and launched a series of quantitative easing programs hoping to keep money, the life blood of our financial system flowing.

Guns & Money

I think we often forget just how dark our future looked during the depths of 2008. At the time, I was writing for The New York Post. I was asked by my editor to find an industry that was doing well and believe me that was a difficult task. The only one I could find was the gun industry. I went to a local gun shop in Norwalk, CT and found lines around the block. Interestingly, most were first time gun buyers. To be fair many were buying weapons feeling that under an Obama administration their gun rights would be diminished. However, there were a significant number of bankers and traders from some of our largest financial institutions who were buying their first weapon, fearing the end of civilized society believing our financial system was about to collapse.

It’s hard not to give Mr. Bernanke high marks for helping us get through those dark days. To truly judge his tenure, we’ll have to wait for the unwinding of the quantitative easing programs orchestrated under his reign. I suspect, when the jury comes in he will get high marks. For now, let me be the first to say; “Thank you for your service, job well done.”