Original source: Jin10 Data

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

Trump has indicated that he is about to select the next Federal Reserve chair. He has also doubled down on his calls for interest rate cuts, recently telling the Wall Street Journal that he hopes the new leader will support his agenda.

So far, the market has shown little clear sign of serious concern that the Federal Reserve will completely abandon its independence. However, investors are still preparing for a Federal Reserve that may be filled with unusual divisions, a potential weakening of the chair's authority, and the persistent threat of more aggressive changes.

Here’s how investors are assessing the different paths the Federal Reserve might take:

Threats to the Market

Analysts warn that a less independent Federal Reserve would pose significant threats to the economy and the market.

While the Federal Reserve controls short-term interest rates, the cost of borrowing in the U.S. is largely influenced by long-term U.S. government bond yields. These yields are determined by investors' expectations of future short-term interest rates, rather than the current rate levels.

If the Federal Reserve aggressively cuts rates while the economy is still in good shape, concerns about inflation and higher rates could push yields and borrowing costs higher rather than lower. A sharp rise in yields could also rattle the stock market.

Not Just About the Chair

So far, the market's reaction has been relatively muted. One reason is that, historically, the Federal Reserve chair has had significant influence over the Federal Open Market Committee (FOMC), which has 12 members responsible for voting on interest rate decisions, but they do not have the authority to set rates unilaterally. Therefore, for Trump to gain clear control over the central bank, several conditions would need to be met.

Some on Wall Street still believe this is possible. The FOMC consists of seven Federal Reserve governors appointed by the president and five regional Federal Reserve bank presidents selected by their local boards and confirmed by the Federal Reserve governors. A majority of members appointed by Trump may attempt to remove any regional Fed president seen as obstructing rate cuts.

Currently, there are 3 governors on the Federal Reserve Board who were appointed by Trump, including 2 from his first term when he was not yet fully seeking loyalists. Earlier this month, these 3 voted unanimously with other governors to reappoint all regional Fed presidents.

Can Trump Secure a Majority?

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

One scenario is that Powell resigns from the Federal Reserve Board after his term as chair ends in May next year—even though the law does not require it (his term as a governor lasts until 2028), this would follow historical precedent.

Another scenario is if the Supreme Court makes a ruling favorable to Trump, allowing him to remove Federal Reserve governor Lisa Cook. The government has accused Cook of lying on mortgage documents, which she denies.

Blake Gwinn, head of U.S. interest rate strategy at RBC Capital Markets, stated that by then, in addition to the two governors from his first term, there would also be three governors appointed during Trump’s second term, increasing the likelihood of removing regional Fed presidents enough to potentially trigger market panic.

He said, "If Trump can replace both Powell and Cook at the same time, that would become very interesting."

More Divisions, More Uncertainty

Even if this scenario does not occur, many investors warn that a more divided Federal Reserve could be enough to create problems in the market. Some even anticipate a situation where the Federal Reserve chair pushes for rate cuts but is overruled by other officials.

In other countries, including the UK, it is not unheard of for central bank governors to hold dissenting views on interest rate decisions, but this would mark a significant change in the U.S.

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

This, in turn, could lead to rising U.S. Treasury yields, as "if you increase volatility and uncertainty, you should be able to get higher yields."

Signs of Concern?

In recent weeks, the spread between short-term and long-term U.S. Treasury yields has widened. Some view this as a sign of growing investor concern over the Federal Reserve's independence, as it indicates they expect lower rates in the short term but not necessarily in the long term.

However, many investors say they have long anticipated that the Federal Reserve will continue to cut rates early next year, even before the new chair takes office.

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

Possibility of Consensus

A common view on Wall Street is that a weak economy will ease divisions within the Federal Reserve and create a consensus for further rate cuts.

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

Although Trump has stated that he believes rates should be at 1% or lower a year from now, many investors believe that the new Federal Reserve chair can implement more moderate rate cuts politically, as long as economic data supports such adjustments.

Bryan Whalen, chief investment officer at TCW Fixed Income Group, said, "By the time that person takes office and starts holding their first meetings, they will have more information and may have more support to lower rates."

The Importance of Communication

Some believe that style is also important: if a Federal Reserve chair can provide sound economic reasons for significant rate cuts, even if the goals align with Trump, it is less likely to unsettle investors than simply echoing Trump’s arguments.

Michael Lorizio, head of U.S. interest rate trading at Manulife Investment Management, stated that if the new Federal Reserve chair communicates "thoughtfully, that not only helps them steer consensus toward their views but also creates stability by avoiding doing anything that could undermine the Federal Reserve's influence on the economy."

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