Insights and Market Perspectives

Who will be the next Fed Chair?

Author: David Stonehouse

October 19, 2017

The Trump administration is thought to have narrowed in on a handful of candidates set to serve as the next Chair of the Board of Governors of the U.S. Federal Reserve Board (Fed), with an announcement expected in the coming weeks.

While a reappointment of Janet Yellen is certainly plausible, whether or not she would accept the nomination is a real question. Further, her firm stance on financial regulation directly conflicts with Trump’s agenda, increasing the chances of a fresh face at the Fed as other candidates fit the bill with experience in monetary policy, consensus-building and a political background.

Betting odds of the next Fed Chair

Source: as of October 10, 2017

Leading up, it was thought to be a head-to-head race between Janet Yellen and Gary Cohn. A renewed term for Yellen could represent stability and the status quo, something that is severely lacking in the Trump administration, and would probably be viewed positively by the markets, with a benign outcome for bond yields and the U.S. dollar. Gary Cohn brings familiarity with Wall Street, a quality highly valued by Trump, and would be supportive of deregulation and relatively stimulative monetary policy. However, he offers no experience in central banking or monetary policy.

As of late, these two have been outpaced by a duo of candidates, Kevin Warsh and Jerome Powell. Warsh brings a hawkish reputation, advocating for faster balance sheet reduction, higher interest rates and Fed reform. However, this hawkish bent would be somewhat tempered by his advocacy of deregulation. If Warsh is nominated as the next Fed Chair, we would likely see an increase in yields and potential for a sell-off in equity markets in anticipation of more restrictive policy. Nevertheless, he appears to favour a gradualist approach to monetary policy and also believes in allowing fiscal policy to take up some of the slack. Furthermore, the Fed is by no means an autocratic institution, having evolved from the Greenspan days. As a result, any initial negative reaction to his nomination may prove to be overdone.

John Taylor remains more of a long shot as a potential successor to Ms. Yellen, as the chart indicates. First, he is more hawkish than the other candidates. While he has tempered his views somewhat in recent years, as expressed by the famous Taylor Rule he devised and to which he has suggested modifications, a Fed under his leadership would likely end up with higher short term interest rates than any other feasible candidate. Second, if he were to convince the Fed to follow his mechanical prescription for interest rates slavishly (an unlikely proposition), it would represent a substantial deviation from the current, more balanced approach. Such a methodology begs the question, why have a Federal Reserve at all (a position some observers have advocated). As an example, if it had been applied in Canada, his rule would have resulted in some extreme outcomes in recent years, as the following chart shows.

Source: Bloomberg, as of August 31, 2017

In fact, under this rule the Bank of Canada would have been hiking rates to over 5% just as oil prices were collapsing and the economy was swooning to a near-recessionary state in the early part of 2015. As it turned out, the Bank of Canada pursued the exact opposite strategy of cutting interest rates twice that year.

Jerome Powell, the newly emerged favorite for the role, should be viewed favourably by markets, holding similar conventional monetary views to Yellen, and more dovish on regulatory policy. In addition, he is an investment banker, not an economist by trade, which would appeal to both Trump and the markets. A nomination for him would mean easier regulation for small banks and little change for larger financial companies. Because of his dovish stance on dual fronts, Powell is likely the most market friendly of all the mainstream candidates.

With Jerome Powell the current favourite, and therefore somewhat priced in, a nomination in favour of someone else could surprise markets, which we would not rule out. Certainly, President Trump has been willing to go with candidates out of left field for various roles. Neel Kashkari fits the bill as an outsider, a businessman (not an economist), and an extreme dove, but administration representatives have indicated that he is not under consideration. Glenn Hubbard and Richard Fisher are other options with a great deal of monetary policy experience, but they range from middle of the road (Hubbard) to somewhat too hawkish for Trump’s taste (Fisher), and both are economists. However, if Trump does elect to nominate an unconventional candidate, he will likely err on the side of a dovish business person who would support deregulation and not disrupt the debt-laden economy and markets too much.

In any event, excessive moves in either direction following the Chair nomination are probably not warranted. Based on the past three decades, which has involved eight nominations spanning three Fed Chairs (Alan Greenspan, Ben Bernanke and Janet Yellen), reaction has typically been tempered. On average, both the long and short end of the bond market initially react hawkishly following nominations, then give back gains and dip slightly lower a month later.

Reaction to Fed Chair nominations: (LHS) 2-year yields; (RHS) 10-year yields

Source: Cornerstone Macro Research, October 12, 2017

The stock market tends to work in reverse, with a fairly muted reaction at first before improving in subsequent weeks, though not by a material amount based on these eight observations.

S&P 500 reaction to Fed Chair nominations

Source: Cornerstone Macro Research, October 12, 2017

Similarly, the U.S. dollar, as represented by the DXY Index, has weakened when the nomination is revealed before quickly regaining losses.

U.S. dollar reaction to Fed Chair nominations

Source: Cornerstone Macro Research, October 12, 2017

Regardless of who the Trump administration nominates in the coming weeks, we expect this history of underwhelming reaction will continue. In essence, continuity will likely be the order of the day from a macro perspective, and the Fed’s evolution to a more team-based consensus-driven approach will likely constrain any maverick initiatives on the part of a new Chair.

One final point to note, though, is that while the focus is on the Chair nominee, there are three other open spots on the Federal Reserve. As a consequence, Trump has an opportunity to more meaningfully reshape the make-up and strategic direction of the Committee over time.

What does this all mean? A gradual, well telegraphed pace of rate hikes are likely ahead…



About AGF Management Limited

Founded in 1957, AGF Management Limited (AGF) is an independent and globally diverse asset management firm. AGF brings a disciplined approach to delivering excellence in investment management through its fundamental, quantitative, alternative and high-net-worth businesses focused on providing an exceptional client experience. AGF’s suite of investment solutions extends globally to a wide range of clients, from financial advisors and individual investors to institutional investors including pension plans, corporate plans, sovereign wealth funds and endowments and foundations.

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Written by

David Stonehouse, MBA, CFA

Vice-President and Portfolio Manager

AGF Investments Inc.

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