Will Yellen Brave Volatility to Bring Financial Markets to Heel?

Talking Points:

All eyes on Fed Chair Yellen as traders price out further rate hikes in 2016
US Dollar set to fall if vague comments leave room for dovish interpretation
Signs of pro-tightening bias to boost US Dollar but rekindle risk aversion

The spotlight has turned to Fed Chair Janet Yellen as she begins two days of Congressional testimony. The remarks come against a backdrop of fizzling rate hike expectations. Fed Funds futures show the markets no longer expect the FOMC to tighten borrowing costs further in 2016. At the start of the year, the Fed envisioned 100bps of on-coming tightening while investors projected a more modest 50bps shift.

On one hand, this means that even neutral commentary may be considered hawkish relative to the markets’ dovish baseline view. In this scenario, the US Dollar is likely to trade broadly higher against its counterparts. The so-called “commodity dollars” may suffer outsized losses as risk appetite evaporates along with hopes for a Fed lifeline for battered asset prices.

Alternatively, it ought to be kept in mind that the markets want to be reassured. This injects a degree of wishful thinking into the equation. For her part, the Fed Chair will almost certainly refrain from plain-spoken commitment on the direction of policy. That means that with a bit of creativity, investors could have enough room to pull whatever message is desired from Yellen’s remarks.

The Fed Chair is surely aware of the lean in the markets’ positioning and of their intent focus on her remarks. If the FOMC consensus favors a relatively sanguine view of recent volatility, she ought to go out of her way to gently but unmistakably nudge traders to re-price rate hikes back into their baseline outlook. If the Committee has become truly unnerved by recent developments, her tone ought to be decidedly vaguer.

Put simply, if the Fed’s view continues to favor some amount of tightening in 2016, Yellen will have to be comparatively clear in saying so, braving subsequent volatility for the sake of avoiding a more violent readjustment down the road. Needless to say, the US Dollar is likely to rise in this scenario. If such clarity is absent, the greenback will probably succumb to renewed selling pressure.

Are markets behaving as DailyFX analysts expected? See our first-quarter forecasts to find out!

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