Since news broke Sunday afternoon that Larry Summers has taken himself out of the running to lead the Federal Reserve, the reaction in financial markets can only be described as elation.
The Standard & Poor's 500 index opened Monday morning up 0.9 percent, and the Dow Jones industrial average up 155 points. Bond markets rallied, as well, with 10-year interest rates falling from around 2.9 percent Friday to 2.79 percent Monday morning, and the dollar fell against other currencies.
Here's the S&P from Friday's close to Monday's open:
And here is the 10-year Treasury bond yield:
What is going on here? The answer that Wall Street analysts are coming up with is simple: Call it the Yellen Rally. It now looks like Janet Yellen, the Fed's vice chairwoman, is the most probable candidate for the Fed chairmanship, and she is viewed as more dovish, or soft on inflation, than Summers. That would imply that the Fed would keep interest rates lower for longer, and would choose a more gradual wind-down of its bond-buying program.
If you look in the weeds of the data, there is some evidence for this effect. For example, futures markets now price in a 35.6 percent chance that the Fed will raise its short-term interest rate target, now near zero, by the end of 2014. On Friday, that probability was a whopping 56 percent. Translation: Markets thought that a Summers Fed would be significantly more likely to raise interest rates next year than they believe a Yellen Fed would be.
Other market measures don't quite fit the story, though. For example, if one expects a Yellen Fed to be softer on inflation than a Summers Fed, you would look for measures of expected inflation to spike on the news of Summers's withdrawal. But Monday morning, the spread between inflation-adjusted and non-inflation adjusted bonds implied that investors expect average annual inflation of 1.8 percent over the next five years -- exactly where it closed Friday (there was some volatility in between then and now, however). Here is the so-called five-year break-even rate:
In other words, markets expect that Yellen would keep low interest rate policies in place for longer than Summers would have, but that don't expect any meaningful increase in inflation.
There may be another factor involved, however, particularly in the rally in the stock market and other risky assets. The prospect of a Summers nomination had put a pall of uncertainty over markets. Allies of the former Treasury secretary had argued that his approach to monetary policy would be broadly consistent with that of the central bank under Fed Chairman Ben Bernanke and Yellen, and certainly that he would have been in no hurry to unwind easy money policies.
But what was actually known about a Summers nomination was this: His Senate confirmation would have been polarizing and contentious, with the outcome in the air until the final vote count. And his views on monetary policy have largely been kept secret, at least in any on-the-record setting.
Both of those point to more uncertainty about the future under Summers than under Yellen, who would likely face a simpler confirmation process and has been crystal-clear in her views on monetary policy. She has given speeches laying out what she expects to be the proper course of policy over the years ahead.
So, it's not just that Yellen may kinda-sorta be more dovish than Summers. Markets are rallying because the prospect of months of being whipsawed by uncertainty over the Fed's future direction have diminished.