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The Bond Column

Yellen's Speech to Set Course for Fed, Money Market Fund Reforms Loom
Updated: 2016-08-22, 08:55:40 ET
Analyst: David Kelland

The problem with Fed speakers is that it is difficult tomentally handicap their public statements. We hear 20 times as much fromsomebody like San Francisco Fed President Williams as we do from Fed Governors Brainard or Tarullo, but the latter two both vote on ratedecisions and Williams does not. We cannot even reliably use the frequentspeakers as representative of the whole FOMC because somebody like St. LouisFed President Bullard went from hawkish to dovish in about six months whileWilliams was going in the other direction. Fed Chair Yellen's speech thiscoming Friday is supposed to unleash some sunlight to burn off the fogsurrounding the future path of Fed policy. We shall see.
The July FOMCminutes, released on Wednesday, showed that several participants thoughtthe committee would have time to react to a sharp uptick in inflation. In thatgroup, I would hazard to say are Fed Governors Brainard, Tarullo, and Powellplus St. Louis Fed President Bullard. Brainard and Tarullo, especially thelatter, are in the camp of waiting to see the whites of inflation'seyes before hiking. If you read Tarullo's interview with Jon Hilsenrath of theWall Street Journal on July 6*, you see a policymaker who will be highlyencouraged by the weak July PPI and CPI data to keep rates on hold. His argument inthat interview, and that of many saltwater economists, is that if we'rebringing people back into the workforce without a large buildup indebt-financed speculation, why hike rates? Brainard was the first one toquestion the usefulness of the Phillips Curve in 2015, and she can beexpected to agree with Tarullo.

On the other hand, New York FedPresident Dudley said this week that September is in play. Boston Fed PresidentRosengren said back on May 12 that the market was far too optimistic about easyFed policy, so he could easily go along for a hike given two straight months of250K+ nonfarm payroll growth. Mester and George are even more hawkish and would also go along withtightening. 

So the way I havethem lined up, Yellen and Fischer are the swing votes for September Fed funds futures currently indicate an 18% probability for a September rate hike, according to the CME website.

In economic data, the news this week was balanced to the upside. The New York Fed's Nowcast model forecast for Q3 U.S. GDPgrowth rose to 3.0% this Friday from 2.4% last week. Growth in industrialproduction and capacity utilization in July were the biggest contributors to the upwardrevision. 

There are other things going on that bear watching as well.Money market fund reform is set to be implemented on October 14. According to the Financial Times:

Over the next six months, funds willcontinue to prepare for October 14, when full implementation of the rules isrequired. At that point, prime funds will be required to publish net assetvalues based on the current value of the assets they hold. That is a bigdeparture for an industry that historically has touted its ability to preservethe value of its investments at $1 a share, and will mean a fund's price willfluctuate along with market conditions.

Also from October, if the fund's assets that can be liquidatedwithin one week fall below 30 per cent the fund can impose a fee of up to 2 percent on redemptions. If that falls below 10 per cent they can impose a fee of 1per cent. The fund could also prevent redemptions completely for up to 10 daysif the 30 per cent threshold is breached. 

These upcoming changes have caused commercial paper yields to rise and some analysts are saying that the reforms are having the same effect as an interest rate hike. Given the record of the Fed embracing one-off events to delay its path of policy normalization, tightening in short-term debt markets could be the next big excuse. To clarify, however, I still see a rate hike by year-end and long-term Treasuries as misaligned with fundamentals. 

- David Kelland,