No surprise with Yellen pick but Fed rotations are an equity risk

Market Realist

Janet Yellen will be the next Fed Chairwoman

President Obama nominated Janet Yellen to lead the Federal Reserve and FOMC (Federal Open Market Committee) yesterday. Ben Bernanke’s reign as most powerful person in the world will end January 31. Yellen has been a big proponent of forward guidance, or clearly communicating to the markets the path of future policy and the factors that the FOMC uses to determine policy. Communication hasn’t been the Fed’s strong suit, with different Fed governors often contradicting each other in the media, causing market volatility. If Yellen is better able to manage the Board’s communications going forward, it would likely lead to decreased volatility in the equity markets.

Based on the views of Bernanke and Yellen, it’s unlikely that Yellen would do anything that Bernanke wouldn’t have done in her place. In other words, the change at the top of the Fed isn’t a big deal. The much bigger issue is the upcoming shuffle in Fed governors.

(Read more: China’s wage inflation: Bad news for corporate profits and banks)

The chair is just one vote

Yellen will still only have one vote out of 12 at FOMC meetings where policy is decided. Other voting members are heads of regional Fed banks and appointees of the President. Regional bank presidents rotate periodically on the board, and two of the more “dovish” (less aggressive) members, Charles Evans and Eric Rosengren, will be replaced by two of the “hawks” (more aggressive) Charles Plosser and Richard Fisher. There will also be two open appointee positions as Bernanke retires and Sarah Bloom Raskin moves to the Treasury. These posts could be filled by more hawkish appointees, shifting the balance on the Board and leading to tighter monetary policy.

Not the time for tighter policy

The breakeven curve is a graph of the difference between real and nominal interest rates. Analysts can use breakevens as a rough estimate of the market’s expectation for future inflation. Currently below-target inflation is expected until 2018. Under these conditions, it’s unlikely that tighter policy would benefit equities, and a shift in the stance of the Board of Governors would be a negative catalyst for equity ETFs such as the SPDR S&P 500 (SPY), iShares Russell 2000 Index (IWM), SPDR Dow Jones Industrial Average (DIA), iShares S&P 500 Index (IVV), and SPDR S&P MidCap 400 (MDY). Emerging market ETFs would likely be positively impacted as well. Politics and monetary policy have been the sole drivers of equity markets for the past four years, and investors shouldn’t expect that to change any time soon.

(Read more: Why Japanese exports could break out of a 5-year slump in 2013)

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