Article / 24 August 2017 at 1:39 GMT

Yellen may echo Greenspan in Jackson Hole speech

Managing Director / Technical Research Limited
New Zealand
  • Former Fed chair Alan Greenspan has repeated his 'irrational exuberance' warning
  • This time his comments were in relation to bonds, not stocks
  • Current chair Janet Yellen is likely to have similar concerns 
  • These concerns may be addressed in her speech at Jackson Hole on Friday

By Max McKegg

Twenty years ago, in prepared remarks, the then Federal Reserve Board chairman Alan Greenspan uttered two words that were destined to become part of financial market folklore: "irrational exuberance". This was the context:
 
“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets ... But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?”
 
The wording looked innocent enough; an observation rather than a prediction. But in Tokyo, the only major market open at the time, the Nikkei slumped 3% and the damage flowed through into European and US markets in the hours that followed. Greenspan had a reputation as a market “guru” and his suggestion US stocks might be a bit overvalued struck a raw nerve.
 
The Fed boss was commenting specifically on stock prices at the time, but earlier this month the now 91-year said that it was “perfectly fair” to say that irrational exuberance was now at play in the bond markets.

hghg
 Bond market bubble? Earlier this month, former Fed chair Alan Greenspan warned of
'irrational exuberance' in relation to bonds. Photo: Shutterstock
 
The current Fed chair Janet Yellen doesn’t have the gravitas of her predecessor. Nevertheless, her position guarantees traders take note of everything she says. Thus the scene is set for Yellen’s speech at the Jackson Hole symposium early on Friday morning, where the focus of her address will be on financial stability. 

The next meeting of the Federal Open Market Committee is not until September 19-20 so she will not be in a position to speak of behalf of the committee as far as monetary policy is concerned. She will, however, be free to discuss issues around balance sheet reduction, a plan her colleagues have already signed off on in principle.
 
The reason Yellen wants to discuss issues around financial stability is likely to be that the markets have yet to adjust to the reality of the Federal Reserve withdrawing itself as an underwriter of the bond market. The Fed may be concerned that bond prices are “unduly escalated”, based largely on “irrational exuberance” at a time when quantitative easing is about to morph into quantitative tightening. 

If so, that reality could hit home all of a sudden, producing a selloff in bonds with implications for financial stability in a range of asset classes.
 
Adding to the risk is that bond market valuation excesses are not confined to the US. Consider this chart of the yield convergence between Eurozone junks bonds and US Treasuries.

fdfd
Source: The Atlas Investor
 
One point Yellen is likely to raise is around the term premium, the extra return investors earn in exchange for taking the risk of owning medium-long term maturity securities. There are various ways of estimating the term premium but all of them agree it is currently negative in the US –hardly what you would expect when the Federal Reserve, the buyer who drove it down there in the first place, is about to withdraw from the market.

gfgf


Source: Morgan Stanley
 
Furthermore, at a time when the Fed is moving to the sidelines, new issuance of US treasuries is set to increase. The situation in a global context is illustrated in the chart below. 

Over the past few years, central bank buying has been more than enough to absorb new issuance but as the Fed stops buying, the Bank of Japan slows down and the European Central Bank begins to taper, new buyers are going to have to take up the slack. Higher yields, perhaps much higher, will be required to entice them.
 
dfd
 
Source: Morgan Stanley
 
Another related issue that Yellen is likely to raise is that of the overall financial conditions in the US. Factors such as record stock prices, low credit spreads and a sinking USD mean that financial conditions have been easing over the last year, despite Fed rate hikes, as shown in the chart below. 

This will an incentive for the FOMC to regain the initiative by sticking with its current “dot plot” of projections for the federal funds rate at its September meeting. Current market pricing is well below those dots and bonds would sell off sharply if traders become convinced the Fed’s forward rates curve, not theirs, is the one likely to become the reality. Yellen will have a chance to make that point on Friday.
 
fdfd
 
 
Source: Goldman Sachs. Create your own charts with SaxoTrader; click here to learn more 
  
Earlier this month we had a blast from the past – former Federal Reserve Chairman Alan Greenspan repeating his “irrational exuberance” warning, this time in relation to bonds, rather than stocks. Current Chair Janet Yellen is likely to have similar concerns and these may be addressed in her speech at Jackson Hole on Friday.

– Edited by Gayle Bryant

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.
2y
John Roberti John Roberti
Dear Max, remarkable article on this delicate subject
2y
Max McKegg Max McKegg
Thanks John

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Tradingfloor.com permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Tradingfloor.com and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Tradingfloor.com is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Tradingfloor.com or as a result of the use of the Tradingfloor.com. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. When trading through Tradingfloor.com your contracting Saxo Bank Group entity will be the counterparty to any trading entered into by you. Tradingfloor.com does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of ourtrading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws. Please read our disclaimers:
- Notification on Non-Independent Invetment Research
- Full disclaimer

Check your inbox for a mail from us to fully activate your profile. No mail? Have us re-send your verification mail