Pity Janet Yellen

It’s tough being the Federal Reserve (Fed) chair—especially these days, as Janet Yellen surely knows.

After an extended period when the entire world hung onto every word she had to say, Ms. Yellen finds herself in a unique and different situation: The bond market is moving on its own—and she, much like many others, is a mere observer. That phenomenon is especially astonishing given that the Fed is getting ready to tighten policy for the second time this cycle after a year-long hiatus.

But before we delve into Yellen’s predicament, what should we expect from the upcoming Fed meeting?

Unless one went on a long solitary cruise on a paddle board across the Atlantic after Mr. Trump got elected and wasn’t in possession of a smartphone, one should be able to figure out that the Fed will likely raise the Federal Funds rate by a quarter of a percentage point. But that’s the easy part.

The Fed’s challenge

The more challenging part is to figure out what else will change in the Fed’s communications. The short answer to that is: not much. Of course, given the strength of the underlying economy, the Fed will probably revise its projected growth rate and inflation outlook slightly upward. But beyond that revision, not a lot is supposed to change. We believe that the Fed will still talk about being gradual in enacting future rate hikes.

Even more importantly, while the bond market gasps for air amid all the talk of fiscal stimulus, tax cuts and reflation, such talk—as far as the Fed is concerned—is still speculation rather than reality and therefore cannot be reflected in its policy statements. Only after it is crafted as legislation and passed through Congress will the Fed react—and therein lies the Fed’s challenge.

After being the primary driver of markets for a long time, the Fed finds itself not being able to factor into its policymaking communication all the issues that have already been priced in by the markets. Therefore, paradoxically, the upcoming Fed meeting will probably be one of the most ignored of recent vintage despite an anticipated decision to hike interest rates.

Therein lies a challenge for the markets as well. With all the talk from the incoming administration about corporate- and personal-income tax cuts, infrastructure spending, the implied uptick in growth and inflation expectations on the long end of the yield curve, the Fed is sticking to its “gradual rate hike” mantra. That’s what is still reflected on the front end of the rates markets, as short-term interest rates have remained relatively anchored.

If the new administration’s fiscal policy regime turns out to be anywhere close to what’s being talked about, it’s quite probable that we end up with economic growth and employment rates that get the Fed really worried about being behind the curve in its rate-hiking path. Unfortunately, a large central bank playing “catch-up” is not a pleasant thought. With that said, the Fed cannot really do much at the moment, as nothing is certain about fiscal policy—and even if it comes to pass, its net impact on economic data will not be felt until the first half of 2018 at the earliest.

It’s also worthwhile remembering where the economy stands today, even before the Trump administration unfolds its fiscal magic: The economy has improved in the second half of 2016—but not by much. Yet the tightening of financial conditions due to a significant rise in interest rates, the dollar and oil prices, will take its toll before the fiscal initiatives take effect. A Fed that is trying to play catch-up amid these conditions would raise serious concerns.

Meanwhile, there are risks of a policy-driven economic slowdown emanating from China due to weakness in the renminbi, capital outflows, and weakness in the housing market—all at the same time.

So, while it’s interesting to see the Fed in a pickle, what’s an investor to make of it all?

The implications for investors

Our base case is that the new administration’s fiscal policy initiatives are likely to be substantive and will help the U.S. and global economies in the short to medium term by steering them away from low growth and disinflation. Such a trend would be supportive of the equity markets and negative for bonds.

But one also has to be cognizant of the fact that risks to the global economy are rising meaningfully as well and should be reflected in portfolio positioning, especially at current equity valuations. We believe it would be prudent to:

1. maintain long exposure to equities while reducing the size of the long position; and
2. cutting back on credit exposure, which seems to have significantly less upside than equities.

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DISCLOSURE:

These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.