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Yellen should sound determined to hike interest rates, shrink balance sheet

  • Fed Chair Janet Yelllen speaks before congressional committees Wednesday and Thursday.
  • She is expected to emphasize that the Fed could raise rates again this year and that it will begin to roll back its giant balance sheet.
  • Markets expect a slightly hawkish Yellen, and any variation could have a market impact.

A more hawkish and strident Janet Yellen will emphasize that the Federal Reserve is on track to both raise interest rates and begin shrinking its balance sheet before the end of the year.

"There's no reason for her to change her tune," said Ethan Harris, head of global economics at Bank of America Merrill Lynch.

Harris and others said Yellen will replay the message that's been coming from the Fed's communications and a number of key members lately. That is that weaker inflation is transitory, and the Fed can move ahead to raise rates another time this year, as well as unwind some of the easy policy it adopted in the financial crisis.

"They laid out the story pretty clearly," said Harris. "Their view, and I think it was confirmed by the jobs number is: We have a strong jobs recovery going on. We're either at full employment or we're likely to be at full employment shortly. The job market shows no signs of slowing down. Even if core inflation readings look a little weak for a couple of months, ultimately that will change. I think that's the basic message. The labor market trumps the inflation picture."

The June employment report showed strong hiring, with a surprise 220,000 jobs created, but wage growth was sluggish — the latest in a series of soft inflation metrics.

For years the top dove at the core of the Fed, Yellen has been sounding much more like a hawk lately — embracing economic improvements and ready to roll back years of easing. She has been making it clear along with New York Fed President William Dudley, Fed Vice Chair Stanley Fischer and others that the Fed is ready to keep moving forward.

Yellen, whose term expires early next year, is expected to give her final semi-annual testimony to the House Financial Services Committee at 10 a.m. ET Wednesday and again before the Senate Banking Committee Thursday morning.

The markets have heeded the Fed's tone change, as well as a perceived change at other central banks, that the world is not in need of the easy policies that began in the financial crisis and have now continued for nearly a decade.

The Fed has said it plans to cut back on the Treasury and mortgage purchases it now makes to keep its $4.5 trillion balance sheet at current levels. The Fed's balance sheet began to grow as it bought assets in the financial crisis and afterward, as a way to help the economy. The Fed continues to replace both mortgages and Treasurys as those securities mature, and it would taper back that program.

Some Treasury strategists believe that the bond market has taken a turn and yields will now hold at higher levels than where they were just a few weeks ago. In the currency market, some strategists say the dollar is also in the process of turning higher, reflecting the fact that the Fed will continue to be active. The dollar index has declined about six percent this year so far, and strategists say it could end the year flattish.

Harris said he believes that bond yields could be at the beginning of a global move higher, but he and others note that fed funds futures do not show that the market is expecting much from the Fed. Economists mostly expect the Fed to announce it will begin unwinding its balance sheet in September and raise its target funds rate range by another quarter point in December.

"You look at the futures market, and the probability [of a rate hike this year] is low. It's 12 percent for September, and December is 54 percent," said Tom Simons, money market economist at Jefferies.

Fed Gov. Lael Brainard and Philadelphia Fed President Patrick Harker both spoke Tuesday, and they were less convincing about a rate hike. Both were cautious, with the lack of inflation an issue. Brainard said the Fed could adjust its balance sheet but not necessarily hike rates.

"You don't get a full pricing in of a rate hike until May 2018," said Simons. "People would say there is not one priced in until June. I think Yellen is going to try to disabuse us of this notion tomorrow. If she repeats what she said [after the June meeting], you can throw away all the dovish talk we heard."

John Briggs, head of strategy at NatWest Markets, said he also expects Yellen to keep to her more hawkish commentary. The surprise would be if she were to sound dovish. "Given her history and the lack of progress on inflation, I don't think she will, but if there is a change it would be in that direction rather than hawkish," he said.

With the recent move higher in Treasury yields, the market could have a strong reaction if there are any surprises from Yellen.

Briggs said he does not believe the market's trajectory has changed, and he expects yields to begin to move lower. "I'm actually bullish on yields here because risk reward is skewed. We've had such a sell-off," he said. Bond yields move opposite prices.

Harris said the markets have been very complacent, given the fact that the Fed has spelled out the program by which it will reduce its balance sheet. He expects it to shrink by $1 trillion and at a pace of $350 billion a year.

"It's no pain, no problem," Harris said. "My personal view is that will be challenged down the road.

"Right now the markets have gotten used to the idea the Fed doesn't follow through," he said. "I think the market in a sense is saying it's not sure anything is going on here. ... I think there's going to be some meeting in the middle, where the markets, the bond market in particular, starts to feel a little bit of pain, some of which we've seen in the last week or so as yields began to rise."

Watch: Market waiting for more guidance on Fed policy