On the eve of a Fed shift: Wall Street is preparing for an interest rate war without "Powell".

Original source: Jinshi Data

Investors are bracing for a potentially drastically different Federal Reserve in the coming year.

Trump has indicated that he is close to selecting the next Federal Reserve chairman. He has also doubled down on his demands for interest rate cuts and recently told the Wall Street Journal that he hopes the new leader will support his agenda.

So far, the market has shown few clear signs of serious concern that the Federal Reserve will completely relinquish its independence. However, investors are still bracing for a Fed that may be rife with unusual divisions, a potential weakening of the chairman's authority, and the lingering threat of more radical change.

Here's how investors can assess the different paths the Federal Reserve might take:

Threat to the market

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

Although the Federal Reserve controls short-term interest rates, borrowing costs in the United States are largely influenced by the yields on long-term U.S. government bonds. These yields are determined by investors' expectations of future short-term interest rates, rather than current interest rate levels.

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

It's not just about the chairman alone.

So far, market reaction has been relatively muted. One reason is that historically, Federal Reserve chairs have wielded significant influence over the 12-member Federal Open Market Committee (FOMC), which votes on interest rates, but they do not have the authority to set rates unilaterally. Therefore, Trump would need to meet many conditions to gain clear control of the central bank.

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 presidents selected by their respective boards of directors and confirmed by the Federal Reserve Governors. A majority of the members appointed by Trump could attempt to remove any regional Federal Reserve president seen as an obstacle to interest rate cuts.

Currently, three members of the Federal Reserve Board of Governors were appointed by Trump, including two from his first term, when Trump had not yet made a concerted effort to find loyalists. Earlier this month, these three, along with other governors, unanimously voted to reappoint all regional Federal Reserve presidents.

Can Trump secure a majority of seats?

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

One possibility is that Powell will resign as a Federal Reserve governor after his term as chairman expires next May—even if the law does not require it (his term as governor will continue until 2028), this move would follow historical precedent.

Another scenario is if the Supreme Court rules in Trump's favor, allowing him to remove Federal Reserve Governor Lisa Cook from her post. Cook has been accused by the government of lying about mortgage documents, which she denies.

Blake Gwinn, head of U.S. interest rate strategy at RBC Capital Markets, said that with three more governors appointed by Trump for his second term, in addition to the two governors who served their first term, the likelihood of removing regional Fed presidents will increase, potentially triggering market panic.

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

More disagreements, more uncertainty

Even if this doesn't happen, many investors warn that a more divided Federal Reserve could cause problems in the markets. Some even anticipate a scenario where the Fed chair pushes for a rate cut, only to have it rejected by other officials.

In some other countries, including the UK, it is not uncommon for central bank governors to disagree on interest rate decisions, but in the US, this would mark a significant change.

John Briggs, head of U.S. interest rate strategy at Natixis Corporate and Investment Banking, said that the views of each FOMC member will carry more weight at that time, which could increase uncertainty about the path of interest rates and lead to greater volatility in the bond market.

This, in turn, could lead to higher yields on U.S. Treasury bonds, because "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 see this as a sign of growing investor concerns about the Federal Reserve's independence, suggesting that they expect lower interest rates in the short term but not necessarily in the long term.

However, many investors say they had already anticipated that the Federal Reserve would continue to cut interest rates early next year, or even before the new chairman takes office.

U.S. stocks showed little concern, with the prospect of further interest rate cuts boosting sectors that could benefit the most, including banks and industrial companies.

The possibility of reaching a consensus

A common view on Wall Street is that a weak economy will ease divisions within the Federal Reserve and create consensus for further interest 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 interest rates should be 1% or lower a year from now, many investors believe that the new Federal Reserve chairman can politically push for more moderate rate cuts, provided that economic data supports such an adjustment.

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

Communication style is very important

Some argue that style also matters: if a Federal Reserve chairman can provide a reasonable economic justification for a sharp rate cut, even if the goals align with Trump's, 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, said that if the new Federal Reserve chair is "thoughtful" in his communications, it will not only help them steer the consensus toward their own views, but also create stability by avoiding anything that could undermine the Fed's influence over the economy.