A dovish speech from Fed Chair Yellen supported strong front-end-led Treasury market gains Tuesday, supporting a bit of a turn back higher in the yield curve after the resumed curve flattening trend over the prior week and also helping TIPS inflation breakevens move higher after four straight down days. Arguing that near-term risks to U.S. growth and inflation remain more elevated and also highlighting uncertainty about the path for neutral real rates and trend GDP growth in the medium term, Chair Yellen made the case for the FOMC to “proceed cautiously in adjusting policy,” reintroducing “asymmetric” risks of hiking too early or too late near the zero lower bound as a key consideration in setting policy. Risks to the economic outlook remain elevated compared to where the Fed saw things coming into the year. That the FOMC’s “baseline outlook for real activity and inflation is little changed” since December after the substantial weakness in risk markets and oil and strength in the dollar earlier in the year and the worsening global backdrop is “because investors responded to those developments by marking down their expectations for the future path of the federal funds rate, thereby putting downward pressure on longer-term interest rates and cushioning the adverse effects on economic activity.” Indeed, far from pushing back against dovish market pricing of the Fed outlook, several times she discussed the importance of the “automatic stabilizer” provided by declining yields and repricing of the Fed outlook in the market as important in preventing a worse outcome for the economy. This has reflected an appropriate understanding of the Fed’s reaction function: “Financial market participants appear to recognize the FOMC's data-dependent approach because incoming data surprises typically induce changes in market expectations about the likely future path of policy, resulting in movements in bond yields that act to buffer the economy from shocks.” Lower yields have provided an important cushion, and stock prices, oil, and the dollar have “largely returned to where they stood at the start of the year,” but “in other respects economic and financial conditions remain less favorable than they did back at the time of the December FOMC meeting.” The global growth outlook has worsened. China remains a source of “uncertainty” and “confusion.” Corporate profits expectations have fallen. Oil prices could fall again, risking a “financial tipping point for some countries and firms” with “adverse spillover effects to the rest of the global economy.” The “dollar could start rising again.” "Unfortunately, the stability of longer-run inflation expectations cannot be taken for granted," and lately "there have been signs that inflation expectations may have drifted down." She still thinks broadly considered that inflation expectations remain consistent with the Fed’s 2% PCE target, but there is "heightened risk that this judgment could be wrong."
