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Traders have been betting Mario Draghi is the central banker most likely to surprise markets at Jackson Hole Friday, but now it actually could be Fed Chair Janet Yellen.
Markets have been waiting for the expecting Draghi, the European Central Bank president, to provide some insight into when the ECB might cut back on some of its quantitative easing. But Draghi spoke already this week and revealed nothing.
Yellen's topic is financial stability, and while many economists believe she will stick to the Fed's script on financial markets and regulation, the bond market has been speculating that she might turn the topic to one that might be more revealing for Fed policy.
"I think [Yellen could] come out and suggest she sees increased risks to financial stability from easy financial conditions, similar to how some of the staff, at least at the last FOMC meeting, had noted valuation pressures have moved from notable to elevated," said Mark Cabana, head of head of U.S. short-rate strategy at Bank of America Merrill Lynch. He said she could indicate an environment where if financial conditions remained easy, that would give the Fed more scope to raise rates. "That would be a hawkish signal that the Fed wants to remain tightening even in the face of relatively low inflation."
Easy financial conditions are evident in credit markets and in the high valuations in stocks. A hawkish tone from Yellen could be a negative for stocks.
"Fed officials have deliberately tried to downplay a chair speech at Jackson Hole," said Cabana. "I think they don't want the market to believe there's going to be some big signal."
Markets have been looking for clues in how the Fed characterizes its concerns about inflation, since it is expected it would be difficult for the Fed to raise interest rates if it does not believe there will be improvement in inflation.
"She's speaking about financial stability, but if she makes a linkage to financial conditions and how the Fed has to be watching that as they adjust policy, then maybe it's not about inflation ... it's about how highly valued these assets are and how the Fed has to drain liquidity," said George Goncalves, head of fixed income strategy at Nomura.
Markets, after a long quiet summer, have been watching Jackson Hole as a moment when two of the world's most important central banks could send signals that they are ready to start a new phase of stepping away from the extraordinary policies they undertook to battle the financial crisis. That also could bring more market volatility.
"Obviously the Fed and ECB are getting closer and closer to pulling the trigger. We think the Fed does do the balance sheet unwind in September. I think people are whistling past the graveyard thinking it will be a walk in the park. We've never seen this before," said Goncalves.
The market currently gives the Fed about a one-in-three chance of raising interest rates in December, but there is a high consensus view that the Fed will begin the process of reducing its $4.5 trillion balance sheet when it meets in September. The Fed has said it would announce a program to pare back the amount of bonds it is buying to replace the Treasurys and mortgages that expire on its balance sheet. The Fed would start with $10 billion and gradually increase the size of its tapering.
The Fed has forecast another rate hike for this year, and many economists expect it in December. However, the markets are skeptical, particularly given the fact that inflation has not picked up again after slowing down earlier this year.
"I actually think they're both going to be pretty cautious, and that's probably a disappointment for the market. Yellen is walking a fine line. This could be a legacy speech for her, so there is going to be a lot of talk about how much they accomplished about achieving financial stability. They do want to offer an olive branch to deregulation and the concept of deregulation. That said, there is a fear within the Fed of doing too much and putting more instability into the system," said Diane Swonk, CEO of DS Economics.
Even though the central bankers are not really expected to make news, Goncalves said there's a possibility they could bring some volatility to a late summer day. "You have a bunch of high-profile people in one place, with a lot of media coverage. Things are going to be said that are going to move markets. The key speakers are critical, but everyone else is going to have an opinion there. What is the Fed's collective voice? There's still an internal debate around inflation but they want to get rates higher," he said.
Yellen speaks at the annual Fed symposium at 10 a.m. ET, and Draghi speaks at 3 p.m. ET.
Draghi has plenty of reason to be low-key at Jackson Hole, and traders have been wondering if he'll talk about the strength in the euro.
"They really do wish they had a depreciation in the euro that would put him in a position to raise rates rather than start the balance sheet first, but they are running out of bonds to buy. They're going to have to start telegraphing it. They're walking on even softer ground than the Fed did. The Fed telegraphed gradualism," said Swonk.
She said Draghi doesn't want to invoke a market reaction to ECB tightening. "He doesn't want a stronger euro right now. His biggest hurdle right now is they don't want to fall through the ice."
The stronger euro is a double-edged sword. If it rises because Europe's economy is strengthening then it has the potential to rise too much and hurt European exports.
Swonk said Draghi is likely to talk about tapering back on bond purchases but not give a timeframe. He could say the ECB is closer to the point where they don't need as much support. "He already flirted with it, and I think he went further than many people thought he should," said Swonk.