This guest commentary was written by Mike O'Rourke of JonesTrading.
“Would I say there will never ever be another financial crisis, probably that would be going too far. But I do think that we are much safer and I hope that it will not be our lifetime and I don’t believe it will be.”
–Fed Chair Janet Yellen June 27, 2017
There are just some things that should never be said, and then there are things that the head of a Central Bank should never say. Yellen’s hubristic comments are rooted in her confidence in the post-crisis reform, oversight and regulation. Her words exude the confidence of an academic Central Banker who believes markets and the economy can be micromanaged on a safe and steady path. The Fed Chair’s comment is alarming because investors and traders are well aware that we live in an uncertain world with infinite possibilities. In addition to the technical failure among Technology names, we suspect the ignorance of Yellen’s comment undermined investor confidence.
Chair Yellen’s assertion above today is eerily reminiscent of Chairman Bernanke’s assertion a decade ago:
“All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.” Ironically, this afternoon Chair Yellen also explained the environment preceding the global financial crisis. “Most advanced economies were pretty stable, macro performance was good. Inflation which has been very high in the seventies and brought down in the eighties was pretty low and stable. Central Bankers were patting themselves on the back, that they understood how to do their jobs and that they had developed frameworks that worked. I think many people thought- the business cycle we figured all of this out, it is fundamentally dead. Perhaps that was a problem also for individuals who thought –you know what, this isn’t a very risky environment perhaps that whole environment was one that encouraged undue risk taking especially with low interest rates- people searching for yield.”
Is that not what Chair Yellen has done today, patting her own back highlighting the safety and soundness of the system? Honestly, if one did not know she was talking about 2007, you would think she was talking about 2017.
Financial stability, financial conditions and asset valuations appear to be high on the Fed’s list of concerns lately. In the past 48 hours, the three most influential Fed officials have weighed in on these topics. NY Fed President Dudley started the week noting that easy financial conditions are allowing the FOMC to continue to tighten amidst decelerating employment and inflation growth. Today, Federal Reserve Board Vice Chair Stanley Fischer gave a speech on financial stability offering a more reasoned perspective:
“However, it would be foolish to think we have eliminated all risks. For example, we still have limited insight into parts of the shadow banking system, and--as already mentioned--uncertainty remains about the final configuration of short-term funding markets in the wake of money funds reform.”
A portion of Fischer's speech was devoted to asset valuations. The Vice Chair described the appetite for risk as “high” while noting that “Prices of risky assets have increased in most major asset markets in recent months even as risk-free rates also rose. In equity markets, price-to-earnings ratios now stand in the top quintiles of their historical distributions, while corporate bond spreads are near their post-crisis lows.”
Chair Yellen also weighed in on asset valuations today.
“Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios, but I wouldn’t try to comment on appropriate valuations and those ratios…asset prices can move and we don’t target asset prices. We’re focused on employment and inflation. What is very important from our point of view is the soundness of the financial system… Asset prices can move they can cause losses to individuals who decided to invest in things that fall in price, but we’re worried about systemic risk and with a strong banking system those kind of repercussions are not at the top of my list.”
It is not every day that the Chair and the Vice Chair of the Federal Reserve both weigh in on asset valuations describing them as “rich.” After a decade of Fed officials (including Yellen and Dudley) openly admitting that policy supported asset prices and was intended to push investors further out on the risk curve, the Chair is attempting to return to the forgotten mantra that policy is driven by developments in the economy.
This appears to be a coordinated effort when taken into consideration with President Dudley’s comments about financial conditions easing. What is most powerful here is that Yellen is redirecting the focus of the Fed Put away from asset values and placing it more narrowly on systemic risks. While we do not believe this Fed has the fortitude to truly step away from supporting asset prices, we do believe there is a great deal of risk associated with Chair Yellen’s overconfidence in the system and the environment she has created.
This is a Hedgeye Guest Contributor research note written by Michael O'Rourke, Chief Market Strategist of JonesTrading, where he advises institutional investors on market developments. He publishes "The Closing Print" on a daily basis in which his primary focus is identifying short term catalysts that drive daily trading activity while addressing how they fit into the “big picture.” This piece does not necessarily reflect the opinion of Hedgeye.