Fed on the Eve of Change: Wall Street Prepares for an Interest Rate Battle Without 'Powell'

Original Source: Jinshi Data

Investors are preparing for a potentially very different Federal Reserve in the coming year.

Trump has indicated that he is close to selecting the next Fed Chair. He has also doubled down on his demands for interest rate cuts, recently telling The Wall Street Journal that he wants the new leader to support his agenda.

So far, the market has shown little sign of serious concern that the Fed will completely abandon its independence. But investors are still preparing for a Fed that could be fraught with unusual divisions, a potentially weakened chair's authority, and the lingering threat of more radical changes.

Here’s how investors are assessing the Fed's potential different paths:

Threat to the Markets

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

Although the Fed controls short-term interest rates, U.S. borrowing costs are largely influenced by the yields on long-term U.S. government bonds. These yields are determined by investors' expectations for future short-term rates, not the current level of rates.

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

It's Not Just About the Chair

One reason for the relatively muted market reaction so far is that historically, while the Fed Chair has significant influence over the 12-member Federal Open Market Committee (FOMC), which votes on interest rates, they do not have the power to set rates alone. Therefore, for Trump to gain clear control of the central bank, many conditions would need to be met.

Some on Wall Street still believe this is possible. The FOMC consists of seven presidentially appointed Fed Governors and five Regional Fed Presidents selected by their respective Reserve Bank boards and confirmed by the Fed Governors. A majority of Trump appointees might try to remove any Regional Fed President seen as obstructing rate cuts.

Currently, there are 3 Trump-appointed governors on the Fed Board, including 2 from his first term when Trump wasn't yet fully focused on finding loyalists. Earlier this month, these 3 voted along with the other governors to reappoint all the Regional Fed Presidents.

Can Trump Secure a Majority?

However, Trump may have more opportunities to pick governors in the coming months, which could change the power balance at the central bank.

One scenario is that Powell resigns from his governor seat after his chair term expires next May—even though not required by law (his governor term lasts until 2028), this would follow historical precedent.

Another scenario is if the Supreme Court rules in Trump's favor, allowing him to remove Fed Governor Lisa Cook. The administration has accused Cook of lying on mortgage documents, which Cook denies.

Blake Gwinn, Head of US Rates Strategy at RBC Capital Markets, said that then, in addition to the two governors from his first term, there would be three governors who are Trump's second-term appointees, increasing the possibility of removing Regional Fed Presidents enough to potentially spook the market.

He said if Trump could replace both Powell and Cook simultaneously, "that would get very interesting."

More Divisions, More Uncertainty

Even if that doesn't happen, many investors warn that a more divided Fed is enough to cause problems in the markets. Some even anticipate scenarios where the Fed Chair pushes for rate cuts but is overruled by other officials.

In other countries, including the UK, it's not unheard of for a central bank governor to be outvoted on rate decisions, but this would mark a significant change in the U.S.

John Briggs, Head of US Rates Strategy at Natixis Corporate and Investment Banking, said that then the views of each FOMC member would carry greater weight, potentially increasing uncertainty about the interest rate path and leading to greater volatility in the bond market.

This, in turn, could lead to higher U.S. Treasury yields because "if you add volatility and uncertainty, you should be able to get a higher yield."

Signs of Worry?

In recent weeks, the spread between short-term and long-term U.S. Treasury yields has widened. Some see this as a sign of growing investor concern about Fed independence, as it suggests they expect rates to be low in the short term but not necessarily in the long term.

However, many investors say they have long expected the Fed to continue cutting rates early next year, even before a new chair takes over.

U.S. stock markets show little sign of worry, with the prospect of further rate cuts boosting sectors that could benefit the most, including banks and industrial companies.

The Possibility of Consensus

A common view on Wall Street is that a weak economy would reduce divisions within the Fed and create consensus for further rate cuts.

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

Although Trump has said he believes rates should be at 1% or lower a year from now, many investors believe a new Fed Chair could politically push for more moderate rate cuts, as long as the economic data supports such adjustments.

Bryan Whalen, Chief Investment Officer of the TCW Fixed Income Group, said: "By the time that person is in place and starts holding their first meetings, they will have more information and likely have more support to cut rates."

Communication Style Matters

Some believe style also matters: a Fed Chair who can provide sound economic reasoning for significant rate cuts, even if the goal aligns with Trump's, is less likely to unsettle investors than one who parrots Trump's arguments.

Michael Lorizio, Head of US Rates Trading at Manulife Investment Management, said that if the new Fed Chair communicates in a "thoughtful manner, it not only helps them steer consensus toward their view but also creates stability by avoiding doing anything that could damage the Fed's influence over the economy."