The Federal Reserve on the Eve of a Turning Point: Wall Street Prepares for a Rate Battle Without "Powell"

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Source: Jin10 Data

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

Trump has indicated that he will soon select the next Fed Chair. He also doubled down on his rate cut demands and recently told The Wall Street Journal that he hopes the new leader will support his agenda.

So far, the market has shown little sign of serious concern that the Fed will completely abandon its independence. However, investors are still preparing for a Fed that may be filled with extraordinary divisions, weakened chair authority, and the threat of more radical reforms.

Here is how investors are assessing the different paths the Fed might take:

Threats to the Market

Analysts warn that a less independent Fed could pose significant risks to the economy and markets.

Although the Fed controls short-term interest rates, borrowing costs in the US are largely influenced by long-term US government bond yields. These yields are determined by investors’ expectations of future short-term rates, not the current rate levels.

If the Fed aggressively cuts rates while the economy remains healthy, concerns about inflation and higher rates could push yields and borrowing costs higher rather than lower. A sharp rise in yields could also stir the stock market.

Not Just About the Chair

So far, the market reaction has been relatively muted. One reason is that, historically, the Fed Chair has enormous influence over the Federal Open Market Committee (FOMC), which has 12 members responsible for voting on interest rates, but they do not have the authority to set rates alone. Therefore, if Trump wants to gain clear control over the central bank, many conditions must be met.

Some on Wall Street still believe this is possible. The FOMC consists of seven Fed governors appointed by the President and five regional Fed presidents elected by district banks and confirmed by the Fed Board. Most members appointed by Trump could attempt to dismiss any regional Fed presidents seen as obstructing rate cuts.

Currently, three Fed governors are Trump appointees, including two from his first term when Trump was not fully seeking loyalty. Earlier this month, these three, along with other members, unanimously voted to reappoint all regional Fed presidents.

Can Trump Secure a Majority?

However, in the coming months, Trump may have more opportunities to appoint members, which could shift the central bank’s power balance.

One scenario is that Powell resigns from the Fed after his term as Chair ends in May next year—though not legally required (his term as a governor will continue until 2028)—which would follow historical precedent.

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

Blake Gwinn, head of US interest rate strategy at RBC Capital Markets, said that at that time, besides the two governors from his first term, three more would be Trump appointees from his second term, increasing the likelihood of dismissing regional Fed presidents, potentially triggering market panic.

He said, “If Trump can replace 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 Fed could cause problems in the markets. Some even expect a situation where the Fed Chair pushes for rate cuts but is vetoed by other officials.

In some other countries, including the UK, dissent among central bank leaders on interest rate decisions is not uncommon, but in the US, this would mark a significant change.

John Briggs, head of US interest rate strategy at Natixis Corporate and Investment Banking, said that at that point, each FOMC member’s views would carry more weight, potentially increasing uncertainty about the rate path and causing greater volatility in the bond markets.

This, in turn, could lead to rising US Treasury yields 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 US Treasury yields has widened. Some see this as a sign of growing investor concern over Fed independence, as it indicates expectations of lower short-term rates in the near term but not necessarily in the long term.

However, many investors say they have already anticipated the Fed will continue rate cuts early next year, even before the new Chair takes office.

The US stock market has shown little sign of worry, and the prospect of further rate cuts has boosted sectors that could benefit most, including banks and industrial companies.

Consensus Possibility

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

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

Although Trump has said he believes rates should reach 1% or lower in a year from now, many investors believe that the new Fed Chair could politically implement more moderate rate cuts as long as economic data support such adjustments.

Bryan Whalen, Chief Investment Officer of TCW Fixed Income Group, said, “When that person takes office and begins holding their first meeting, they will have more information and may garner more support to lower rates.”

Communication Style Matters

Some believe style is also important: if a Fed Chair can provide a reasonable economic rationale for significant rate cuts—even if their goals align with Trump’s—it is less likely to unsettle investors than simply echoing Trump’s arguments.

Michael Lorizio, head of US interest rate trading at Manulife Investment Management, said that if the new Chair communicates “thoughtfully,” it will help bring consensus to their views and create stability by avoiding actions that could undermine the Fed’s influence over the economy.