Traders play war game for Trump’s Fed pick from Yellen to Warsh

NEW YORK: Whether Donald Trump follows through on announcing a new Federal Reserve chair in the coming weeks or not, traders across financial markets have already tipped their hands.

Former Fed governor Kevin Warsh (pic) ... he’s seen as the most hawkish of the candidates, meaning more rate hikes and a flatter yield curve.

Reappointing Janet Yellen would be a sigh of relief, since her dovish stance is well-known, so less volatility from stocks to currencies.

Current Fed governor Jerome Powell, who is jockeying for the lead in betting markets, falls somewhere in the middle.

Sure, the next Fed chair is just one person, who can’t unilaterally set the course of US monetary policy and financial regulation.

But, as seen on Sept 29 when it was revealed that Trump and Treasury Secretary Steven Mnuchin had met with Warsh, the markets view the next leader as critical at a time when the central bank is attempting to tighten at a faster pace than the rest of the world and unwind its unprecedented stimulus measures.

“In general, everybody is going to be more apt to just continue what Yellen started,” said John Briggs, head of US rates strategy at NatWest Markets.

A Warsh-led Fed versus Yellen’s “might not be the difference between eight rate hikes and two, but it might be the difference between two and four.”

And that difference, in turn, has implications for investors. Here’s how Treasuries, the dollar and stocks will likely react to each of the candidates assuming the Fed chair role.

Kevin Warsh

Let’s start with Warsh, the biggest game changer.

“The reason the market will react the most to him is because he’s been the most vocal in his criticism,” said Priya Misra, head of global rate strategy at TD Securities, which views Warsh as the most likely pick.

“It’s clear he’s in the hawkish camp, and that tells you the curve has room to bear flatten.”

The yield spread between threeand 30-year Treasuries fell six basis points on Sept 29, the biggest decline of 2017, on reports of the TrumpWarsh meeting.

The market reaction would be at least the same magnitude if he were officially nominated, said Ruslan Bikbov, US rates strategist at Citigroup Inc.

Jerome Powell

Powell has been a fast-riser in the betting markets after Politico reported he’s the Treasury Secretary’s preferred candidate.

At one point on Tuesday, he had the highest odds. Jaret Seiberg at Cowen & Co said “he is now positioned as the GOP alternative to renaming Yellen.”

Yet for traders, the differences between him and Yellen are small.

Powell is seen as slightly more open to deregulation than Yellen, and that, combined with his prior experience with the Fed, should boost financial stocks, Seiberg said.

Janet Yellen

The embodiment of the status quo, Yellen remaining in her current position would, at the very least, suppress volatility across markets. “I don’t know if she’d be seen as dovish, since even Yellen herself is trying to look through low inflation readings right now, but she will be more known and better understood, so less volatile,” Briggs said.

That means stocks rally, while the yield curve steepens to undo some of the flattening from the prospect of Warsh’s nomination, Briggs said.

Some wonder if Yellen even wants to be re-nominated.

Gary Cohn

Once seen as a front-runner, Cohn’s prospects have dimmed in part because of his criticism of Trump’s response to the events in Charlottesville. He also has no experience at the Fed.

“It’s not clear what his actual policy would be – there’s a lot of mixed opinions about that,” said Aaron Kohli, US rates strategist at BMO Capital Markets. “Certainly he’s spearheading the tax-reform effort, so that suggests he’d be more on the dovish side.”

As far as shaking things up, “he’s somewhere in-between.”

John Taylor

An evergreen candidate, Taylor would bring his famous maxim with him to the position, which could roil markets.

That’s because the Taylor Rule would have the fed funds rate at about 3.5%, rather than the current 1.16% effective rate.

“The concern is if one of the rules-based people come in, they’ll want to jack up the funds rate pretty quickly,” Briggs said. “A John Taylor Fed would be seen as the most aggressive, because his rule has rates up fairly high.”

Like with Warsh, that would mean higher short-term Treasury yields, a flatter curve and a stronger dollar.