Market Update Chairman Yellen’s statement Thursday that the Fed was still expecting to hike rates later this year triggered a selloff in Treasuries (10yT up some 10bp to a peak above 2.18%) but coincided with a rally in risky assets worldwide. The conditions for the rate hike still sounded far from being met. But at least it was a nudge in the hike direction and a reminder that the Fed has teeth, lest we forget that after the post-FOMC dovish haze. The stock rally on Thursday and Friday morning (a sell-off in biotech stocks hurt the Nasdaq and S&P in late hours), despite Yellen’s less dovish stance, will vindicate those who argued that by sounding too dovish at the September meeting the Fed hurt confidence and contributed to the risk sell-off. Along the same line, Thursday’s more confident message supposedly supported risk taking. We have little sympathy for that theory. Instead we reckon that the Fed has lost control of risk sentiment. Indeed, we argue that risk sentiment now has a strong impact on Fed expectations, but the Fed itself has a limited impact on risk. The negative correlation between 2-year USD rates and VIX supports that view. If the Fed was in charge, rising (falling) Fed fears would push VIX higher (lower), and the correlation would be positive. Instead, improving (deteriorating) risk sentiment, i.e. a fall (rise) in VIX, pushes 2-year rates higher (lower) – hence the negative correlation. Graph 1: VIX vs. 2y USD rate… negative correlation Source: SG Cross Asset Research/Rates
