Insights from Morgan Stanley
Yellen’s Semi-Annual Testimony:
Selective Hearing


Perception is everything. In what were incredibly brief remarks, we feel Chair Yellen
stuck close to the benign spirit of the January FOMC statement, though the bond
market felt differently. Whereas Yellen surprised markets in her January 18 speech by
saying, “as of last month, I and most of my colleagues…were expecting to increase our
federal funds rate target a few times a year…”, this time she chose to steer clear of
numerical assignment or time stamp in terms of further hikes. Instead, the Chair cited
progress on the Fed’s dual mandate, and in light of this progress “further gradual
increases” in the fed funds rate appear warranted. We couldn’t agree more and expect
the Fed to deliver two additional rate hikes this year. Where we differ greatly from
consensus is how soon the next hike is delivered.
In our view, the probability of a rate hike in 1H17 should remain low and the bond
market is getting ahead of itself. Chair Yellen laid forth a tall order around the dual
mandate that both employment and inflation need to evolve in line with the Fed’s
expectations, and progress on both fronts will be examined at upcoming meetings. To
that end, we are entering a difficult period for growth in core PCE inflation and expect
year-on-year readings to remain soft through the spring (see Core PCE Inflation:
Weakness Into Spring, February 2, 2017). The path for core PCE we envision is not the
stuff that gets markets, or the Fed, excited about rate hikes.
As such, we expect the next rate hike to come in September, while at this point
consensus still places the greatest probability on the June meeting. Our expectation for
September is supported by two key assumptions—the Fed’s reaction function and fiscal
policy. After having undershot the 2% inflation goal for 8 straight years, the Committee
will want to allow inflationary pressures to build before moving again, and will want to
allow tax reform to take shape (something we are expecting in the fall in our current

Market Reaction
In immediate reaction to headlines from Fed Chair Yellen’s Monetary Policy Report to
Congress, 5-year Treasury yields rose 7bp. Markets now price a 20% probability of the
next hike by March and a 90% probability of the next hike by June. Bond market
investors were hoping for a hawkish outcome, based on Eurodollar positioning metrics,
and the headlines did not disappoint. The headlines, written with a hawkish spin,
included, “Yellen repeats waiting too long to tighten ‘would be unwise'”, as if the fact she
repeated something she said in her last major speech would be unusual.
The “waiting too long” language was not a new riff from Yellen. She’s been saying similar
things since at least November last year (our emphasis):

Another headline also made the underlying speech appear more hawkish: “Yellen: wages
have picked up, labor market improvement widespread”. Here is the actual quote from
Yellen’s testimony (our emphasis):

In addition, the pace of wage growth has picked up relative to its pace of a few
years ago, a further indication that the job market is tightening. Importantly,
improvements in the labor market in recent years have been widespread, with large
declines in the unemployment rates for all major demographic groups, including
African Americans and Hispanics.

That the labor market has been tightening over the past few years is not a matter of
debate. Also not up for debate is the fact that the labor market has improved on a
widespread basis in recent years, as evidenced by a wide array of labor market metrics.
Why reporters found these comments worthy of a headline alludes us.

Perhaps the Most Important Line

From our perspective, the following line was the most important one in Yellen’s
At our upcoming meetings, the Committee will evaluate whether employment and
inflation are continuing to evolve in line with these expectations, in which case a
further adjustment of the federal funds rate would likely be appropriate.
Two things stand out:

1. Yellen does not point to the March FOMC meeting alone, which suggests the
markets have the balance of probabilities right: a rate hike by the March FOMC
meeting looks less likely than a rate hike by the June meeting—also in line with our
2. Both employment and inflation need to evolve in line with the Fed’s expectations in
order for the Fed to deliver the next rate hike.

Remember our view on the near-term path of inflation and the risks around that path.
We think core PCE inflation will disappoint into the spring as the bar in 1H17 is quite high.
Then, in 2H17, we see more downside risk to our forecast than upside risk (see Core PCE
Inflation: Weakness Into Spring, February 2, 2017). Also, early indications on the January
PCE report look disappointing—see today’s PPI commentary: “We see PCE healthcare
services, which makes up 19% of core PCE inflation, coming in at 0.0% in January.”
While we don’t know exactly what the Fed expects for PCE inflation over the near term,
we know what the Fed expects for inflation by the end of the year. We also know what
the Fed expects for the labor market. In the December FOMC minutes, we saw how
many participants forecasted the unemployment rate and PCE inflation rates at
different levels by the end of 2017. Exhibit 1 shows that just over half the Committee
expects the unemployment rate to average 4.4% or 4.5% in the 4th quarter of 2017.
While the bar for the labor market may appear low, the bar for inflation appears high to
us. Exhibit 2 shows that 8 participants project core PCE inflation at 1.9% or 2.0% by yearend,
and 9 participants project headline PCE inflation at the same levels. While we also
forecast core PCE inflation at 1.9% by year-end, our forecast is based on tax reform that
results in much higher fiscal deficits being passed this year (we are not building in the
Border Adjustment Tax into our base case).

The Balance Sheet Is Not a Substitute
Early on in the Q&A, the Chair reiterated the Committee’s exit strategy of reducing the
balance sheet over time and returning it to consisting primarily of Treasuries. We
recently updated our views around the Fed’s balance sheet (see US Economics &
Strategy: The Fed’s Balance Sheet, January 27, 2017). We think the Fed will begin to
reduce the size of its $4.2 trillion SOMA portfolio in April 2018 by ceasing MBS
reinvestments only.
As markets price this in, we think mortgages will widen 15bp, but intermediate Treasuries
will outperform relative to expectations. We do not think ending Treasury reinvestment
is necessary for a gradual normalization of the balance sheet; the economy should grow
into the Fed’s Treasury portfolio in about a decade.
Do not expect the Fed to be an activist. Chair Yellen refuted any idea the Fed wants to
reduce its balance sheet in an active way that could directly substitute roll-off for rate
hikes. This suggests the Chair is sympathetic to former Chair Bernanke’s view presented
in this January 26 blog post: “To minimize such risks, it seems more prudent, once the end
of reinvestment is announced, to allow that process to continue without further
management—that is, to simply allow the balance sheet to run down until it reaches
the desired size, barring some major deterioration in the outlook.”

How to Position in Rates?
We continue to suggest investors position for a steeper 5s30s yield curve (see Global
Interest Rate Strategist: The Push and Pull of Politics, February 13, 2017). Without the
Fed hiking interest rates in March, and given the global event risks between now and the
June FOMC meeting, we don’t think investors already positioned for a rate hike by June –
a rate hike that is already fully priced, by the way – will be able to hang on to those
short positions, which suffer from 11–16bp of negative rolldown every 3 months.

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