The Eve of a Fed Pivot: Wall Street Girds for Rate Battle Without 'Powell'

Original Title: "Eve of Fed Upheaval: Wall Street Braces for a Rate War Without 'Powell'"

Original Source: Golden-Ten Data

Investors are preparing for what could be a significantly different Fed in the year ahead.

Trump has indicated he is about to pick the next Fed chair. He has also doubled down on his call for rate cuts and recently told the Wall Street Journal that he wants the new leader to back his agenda.

So far, the markets have shown little sign of serious concern that the Fed will entirely abandon its independence. But investors are still bracing for a Fed that could be marked by unusual discord, a weakened chair, and persistent threats of more radical change.

Here is how investors are evaluating the different paths the Fed might take:

Threats to the Market

Analysts warn that a less independent Fed would pose a significant threat to the economy and the markets.

While the Fed controls short-term rates, U.S. borrowing costs are heavily influenced by longer-term U.S. government bond yields. And these yields are determined by investors' expectations of future short-term rates, not current rate levels.

If the Fed aggressively cuts rates while the economy is still doing well, concerns about inflation and higher rates could push up, not down, yields and borrowing costs. A sharp rise in yields could also roil the stock market.

Not Just About the Chair

Market reactions have been relatively muted so far. One reason is that historically, while the Fed chair has had significant influence over the Federal Open Market Committee (FOMC), which has 12 voting members responsible for rate decisions, they do not have sole authority to set rates. So, for Trump to gain explicit control over the central bank, many conditions would need to be met.

Some on Wall Street still see this as possible. The FOMC consists of seven Fed governors appointed by the President and five regional Fed presidents selected by regional Fed boards and confirmed by the Fed governors. A majority of Trump-appointed members could try to oust any regional Fed presidents seen as obstacles to rate cuts.

Currently, there are three Trump-appointed governors on the Fed board, including two from his first term when Trump wasn’t yet fully focused on finding loyalists. Earlier this month, these three, along with other governors, voted unanimously to reappoint all the regional Fed presidents.

Can Trump Secure a Majority?

However, in the coming months, Trump may have more opportunities to appoint governors, potentially shifting the Fed's balance of power.

One scenario is for Powell to resign from the Fed's Board of Governors after his term as Chair expires in May next year — even though the law does not require it (his term as governor runs until 2028), following historical precedent.

Another scenario is if the Supreme Court makes a ruling favorable to Trump that allows him to remove Fed Governor Lisa Cook. The government has accused Cook of lying on mortgage documents, which Cook denies.

Blake Gwinn, head of U.S. rate strategy at RBC Capital Markets, said that at that point, in addition to the two governors from his first term, there would be three governors appointed by Trump for his second term, increasing the likelihood of local Fed chair firings, enough to possibly trigger market panic.

He said, if Trump could replace both Powell and Cook at the same time, "that would be very interesting."

More Division, More Uncertainty

Even if this scenario does not come to pass, many investors warn that a more divided Fed is enough to cause issues in the market. Some even anticipate a situation where the Fed Chair pushes for rate cuts, only to be overruled by other officials.

While central bank governors dissenting on rate decisions in some countries, including the UK, is not unheard of, it would mark a significant shift in the U.S.

John Briggs, head of U.S. rate strategy at Natixis Corporate and Investment Banking, said that each FOMC member's views would carry more weight, potentially increasing uncertainty around the rate path, leading to greater bond market volatility.

This, in turn, could lead to a rise in U.S. Treasury yields because "if you increase volatility and uncertainty, you should be rewarded with a higher yield."

Signs of Concern?

In recent weeks, the spread between short-term and long-term U.S. Treasury yields has widened. Some see this as a sign that investors are increasingly worried about the Fed's independence, as it suggests they expect rates to be lower in the short term but not necessarily in the long term.

However, many investors have indicated that they have long expected the Fed to continue cutting rates early next year, possibly even before the new chair takes office.

The U.S. stock market has shown little concern, with the prospect of further rate cuts boosting sectors that could benefit the most, including banks and industrial companies.

Likelihood of Consensus

A widely held view on Wall Street is that a weakening economy will ease internal Fed divisions and lead to consensus for further rate cuts.

Over the past 15 months, the Fed has lowered its benchmark federal funds rate from 5.25%-5.5% to 3.5%-3.75%.

While Trump has stated that he believes rates should be at 1% or lower a year from now, many investors believe a new Fed chair can politically navigate a more moderate easing path as long as economic data support such adjustment.

Bryan Whalen, Chief Investment Officer of TCW Fixed Income Group, said, "By the time that person takes the helm and has their first meeting, they will have more information and potentially more support to reduce rates."

The Importance of Communication

Some also believe style matters. If a Fed chair can provide sound economic justifications for a significant rate cut, it is less unsettling for investors even if the goal aligns with Trump, rather than merely echoing Trump's arguments.

Michael Lorizio, Head of U.S. Rates Trading at Amundi Pioneer, stated that if the new Fed chair communicates "thoughtfully, not only does that help guide consensus towards their view, but it also helps to create stability by avoiding doing anything that could jeopardize the Fed's economic influence."

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