Inside investment: The Yellen put is a golden call

Andrew Capon
Published on:

Janet Yellen is eminently well qualified to lead the Federal Reserve. But investors should not assume that the continuation of policy as normal comes without risk. Her dovish stance on inflation is worth noting and hedging against.

Rarely do the worlds of Viz and high politics collide. In deference to our international readers it should be explained that Viz is an irreverent UK comic with a line of humour directed squarely at adolescent boys. Its iconic characters include Cockney Wanker, The Fat Slags, Mr Logic ("such is my name, therefore one may infer that this strip is in some way about me") and Sir Fred Goodwin the Fat Cat, which might be a reference to a former Scottish banker. However, the strip that came to mind when watching the institutional dysfunction in Washington last month was S.W.A.N.T. (Special Weapons and No Tactics).

A parody of US SWAT teams, a S.W.A.N.T. comic strip would invariably end with pointless carnage and enormous collateral damage. Such has been the recent behaviour of the Republican Party. By closing down the government before the negotiations over the debt ceiling had begun in earnest, tactics triumphed over strategy. The Republicans also wasted valuable political capital in all matters financial and fiscal. GOP, it now seems, stands for Grumpy, Old and Partisan.

That is significant because the indebtedness of the US government is an important issue. It also matters because the Founding Fathers wanted Congress to hold the executive branch to account. Sadly, the irresponsible petulance of the Taliban wing of the Republican Party has ensured that Janet Yellen’s elevation to the chair of the Federal Reserve next February will be no more than a coronation. There should have been a proper debate.

Yellen is intellectually brilliant, erudite and a fantastic communicator. These three attributes mean her CV fits the mould of the modern central banker perfectly. But, as a serving member of the Federal Reserve board since the 1990s, she represents the policy status quo. In part it was those policies that plunged the global economy into recession and brought the financial system to the brink of collapse. Yellen’s public pronouncements suggest more of the same in spades. The fact that Alan Greenspan recently endorsed her candidature whilst promoting his new book is evidence of that.

Yellen believes that the Phillips Curve "provides a coherent and useful framework for thinking about the influence of monetary policy on inflation". What the Phillips Curve certainly does is speak volumes about what is wrong with academic economics. The inverse relationship between unemployment and inflation was true of every UK economic cycle between 1861 and 1957 studied by William Phillips. It was a model that worked until it did not. In the 1970s the UK experienced both high levels of unemployment and inflation. Economics is not amenable to modelling, and finance even less so, because all of the assumptions that lie beneath neat theories (seamless liquidity, a level playing field of information, investor rationality) are just plain wrong.

Distend and debauch

The false belief that economics is a science is a widespread sin in the profession. But Yellen’s particular vice appears to be an Arthur Burns-like willingness to dismiss the risk of inflation. Of course, she may be right. One of my standard questions to the best and brightest in the asset management and investment banking worlds is whether monetary experimentation will lead to inflation, or if all policymakers have done is avert a savage debt deflation cycle? Views are divided.

But when the soon-to-be most important central banker in the world says: "The FOMC will take a ‘balanced approach’ in seeking to mitigate deviations of inflation from 2% and employment from estimates of its maximum sustainable level", it is clear where that balance is tilted. Yellen also seems very likely to continue with the Greenspan put, adjusting policy and boosting liquidity every time the stock market swoons. With rates at the zero bound, the Fed’s already distended balance sheet is likely to be debauched yet further.

This is great news for risk assets. It is not surprising that stock market indices are pushing toward new record highs. Faced with the choice of an equity from a high-quality company, with relatively transparent cashflows and adequate dividend cover, or a cov-lite loan or PIK note from a junk borrower (currently both types of paper, generally only fit for flushing, are seeing rates of issuance last experienced in 2007) it seems obvious where the risk-reward is in your favour given this policy backdrop.

Further, if Yellen is wrong and inflation did take hold, it would be catastrophic for nominal bonds. Equities would only be a partial hedge. This has forced a personal portfolio rethink. In January 2010 this column derided the fetishism of gold bugs, reasoning that the deflationary forces unleashed by bank and consumer deleveraging, globalization and productivity improvements would undermine any fundamental case for the barbarous relic. However, we are now three years on. Deleveraging still has further to go, but the credit multiplier is showing signs of life. Meantime, monetary policy is stuck in ultra-accommodative mode and central banks are led by über-doves.

The chances of a policy misstep or miscalculation are increasing. Gold is now 30% below its 2011 highs and GDX (the Market Vectors Gold Miners ETF) trades at a 0.95 price-to-book ratio. Over the past decade the NYSE Arca Gold Miners Index is basically flat and negative in real terms. When Gordon Brown was selling the UK’s gold reserves between 1999 and 2002 at around $275 an ounce, that seemed to me a very powerful contrarian signal. Yellen’s coronation at the Fed is a similarly golden opportunity.

Andrew Capon has won multiple awards for commentary and journalism on markets, investment and asset management. The views expressed are the author’s own.