The Day After: Yellen’s Big Mistake

So here we are, the day after a Fed hike that was supposed to (and by a lot of accounts needed to be) dovish.

Wednesday’s lackluster CPI and retail sales data should have been a “game changer” for Yellen’s messaging, a lot of folks contended, going into 2 p.m. EST. Simply put: by the time the Yellen presser rolled around, it seemed like the financial universe had planted themselves squarely on the “listen to inflation” side of the argument (the other side of that being “listen to the ostensibly overheating labor market”).

Instead, her comments were perceived as hawkish (in line with what at least one observer believes is the norm for the “diminutive woman with a pixie haircut”).

That triggered a rebound in the dollar (which had plunged earlier in the session on the CPI print), but probably the best way to visualize the whole thing is simply to look at the curve. At this point the 2s10s has collapsed below 80bps:

 

One person who is predictably irritated with this is former FX trader Mark Cudmore who on Wednesday morning predicted that you were going to be sorry for putting a gun to Yellen’s head and forcing her to hike.

Cudmore, like us and many others, thinks the Fed’s inflation targeting mandate might be antiquated, but importantly, he thinks that as long as they’re sticking to it, they have to be allowed to act as such. In other words: the market shouldn’t pigeon hole them into hiking when the deflationary impulse is building. This morning, Cudmore is out reiterating that. Here’s are the bullets from his latest note:

• It may seem counter-intuitive but the Fed’s optimistic perspective on the U.S. economy makes it more likely that 10-year Treasury yields have more downside.
• The problem for Janet Yellen is that the data is there for us all to see: What few inflation pressures did exist are now receding rapidly. By failing to comprehensively address the fact that the committee’s projections are constantly over-optimistic, they further undermine their own credibility
• The Fed hasn’t been correct for seven years. The evidence would suggest their models are broken. Yellen still cites the Phillips curve even though some of her own committee have questioned its validity and it has shown no sign of working as anticipated in recent years
• Temporary factors are cited as the reason for low inflation -– for example a decline in mobile phone bills — without acknowledging that the technological innovation frequently behind such factors isn’t a temporary phenomenon
• Technology is also helping drive down external inflationary pressures coming through from commodity prices. And the committee’s models don’t seem to adequately account for demographic disinflationary impulses either
• If Yellen had acknowledged that the policy frameworks she and her colleagues have been using since the crisis have all been incorrect, then we might believe she has a chance of now applying a more appropriate framework and has a credible plan to sustainably hit the inflation target
• Instead, traders can’t help but feel that no lessons are being learned and will have to raise the probability of a major policy mistake in market pricing. This means that the yield curve will need to flatten further through long-end yields dropping