Who’s afraid of Janet Yellen?

July 16, 2014

July 16 (Reuters) – Markets aren’t afraid of Janet Yellen,
but you might want to be.

Yellen and her colleagues at the Federal Reserve Board took
unusually frank aim at frothy valuations in social media and
biotech shares, as well as at parts of the debt markets, in
testimony before Congress this week. The market reaction
amounted to a politely stifled yawn.

This is both telling, and worrying.

That’s because Yellen herself is putting great stress on
macroprudential policies as a primary means of defense against
bubbles. Well, jawboning the market is an important part of
macroprudential policy and we can already see that is not
working.

That’s bullish news for risk assets in the short term.
Markets are not wrong to have rallied over the last two days.
Longer term the risks are skewed a bit more than previously
toward the ugly end of the probability tail.

Yellen’s critique, perhaps the most remarkable by a Fed
chair since Alan Greenspan’s “irrational exuberance” speech in
1996, came in two parts.

As part of her remarks during mandated testimony before
Congress, while playing down the idea of a generalized bubble,
Yellen expressed concern about some kinds of debt.

“In some sectors, such as lower-rated corporate debt,
valuations appear stretched and issuance has been brisk.
Accordingly, we are closely monitoring developments in the
leveraged loan market and are working to enhance the
effectiveness of our supervisory guidance,” she said.

It should be noted that calling out a market in this way is
part of the way in which the Fed provides supervisory guidance,
and yet there was no rash of pulled bond deals or repricings of
loans in syndication this week, nor is there likely to be.

More remarkable, especially in its specificity, were remarks
in the Monetary Policy Report prepared by Yellen and the Federal
Reserve Board and presented along with her testimony.

“Valuation metrics in some sectors do appear substantially
stretched – particularly those for smaller firms in the social
media and biotechnology industries – despite a notable downturn
in equity prices for such firms early in the year,” the FRB
report said.

That’s really quite a statement for Fed officials, a group
known for speaking in generalities about asset markets rather
than being sector experts.

UNDERWHELMING REACTION

In contrast to Greenspan’s irrational exuberance speech,
launched in the early days of the dotcom mania and which sent
markets tumbling, the reaction to this analysis was muted.

The iShares Nasdaq Biotechnology ETF fell 4 percent
over two days but is still up more than 10 percent this year.

Social media companies also fell, but not by hugely
eye-catching amounts. Facebook, for example, fell on
Tuesday after the testimony, but rallied Wednesday to stand only
about a half a percent down from Monday’s close.

All in all, the Fed expressed concern about valuations and
the market said it didn’t really care.

That makes perfect sense, but raises huge issues for how
Yellen and the Fed will conduct policy and what the ultimate
outcomes will be, both for investors and the economy.

Investors care about what Fed officials say not because they
trust their expertise as company evaluators or even as
economists, but because they can affect the value of assets
through policy. Therefore if Yellen, or any other Fed official,
tells you they are worried about X, Y, or Z market you will
price that in to the extent that you think they will tighten
policy as a result.

Yellen, however, has come out strongly in favor of
macroprudential efforts to maintain financial and market
stability, arguing that monetary policy should be calibrated to
manage inflation and employment. Macroprudential policy has two
main parts, the most important of which is regulation.

Jawboning, talking the market in one direction or another,
has also traditionally been a meaningful tool by which central
banks encourage prudence.

In more or less ruling out monetary policy as a means of
managing bubbles, Yellen has effectively broken the link between
monetary policy and macroprudential jawboning. She and the Fed
may slowly over time squeeze the juice out of the leveraged debt
markets through regulatory efforts, but her ability to affect
animal spirits in public markets by expressing concern about
them is now greatly diminished.

For investors that means you can ignore what she and her
colleagues say about markets, but pay attention to what they say
about inflation and employment. And so long as they are
indicating that there is still further work for monetary policy
to do there in propping things up, you ought to buy rather than
sell risk.

There are lots of ways this can end badly, though none of
them are preordained. Inflation can get out in front of the Fed,
prompting a slam on the monetary brakes later, or a bubble in
some market or other can grow and eventually burst.

Until one of those becomes more likely, expect frothy
markets.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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