Trump’s risky ‘Powell play’

THE US Federal Reserve (Fed), especially its chair Jerome Powell, has come under increasing pressure from US President Donald Trump to cut the benchmark Fed Fund Rate (FFR).

While Powell has categorically expressed that he will stay on until his term expires in May next year, the president is just fed up with Powell due to his lack of action in cutting the FFR and has called Powell all sorts of names.

However, everything changed late on Tuesday when Trump categorically denied any plans to dismiss the Fed chair. Nevertheless, Trump still insisted that Powell should do the right thing by lowering the FFR.

Fed’s focus

The Fed’s mandate is clear. It has a dual mandate – to ensure that the US economy is supported by a robust employment market (maximum employment) and to ensure the price of goods and services remain stable (price stability).

The Fed ensures the mandate is appropriately executed via adjustment in the FFR, which is decided by the Federal Open Market Committee (FOMC) in scheduled meetings.

Only in extreme circumstances does the Fed carry out unscheduled rate cuts. That happens when there is market chaos and uncertainty of the highest order.

In carrying out its mandate, the Fed is very much data-driven, it will either communicate to the market in a hawkish or dovish tone before taking rate action. This is to ensure the market is well prepared when it comes to rate moves.

The Fed also communicates to the market in various forms, including after every FOMC meeting, as well as when it makes quarterly adjustments to its economic projections.

The Fed also communicates to the market its famous dot plot, which is the highlight of where rates are going for the current year and into the future. The market takes its cue from Fed’s guidance and the Fed Fund Futures almost mirrors Fed’s expectations most of the time.

There have been times when the Fed was behind the curve as well as ahead of the market’s expectations but over time, either the Fed or the market adjusts in terms of where the FFR would be.

Interest rates – the price of everything

The man on the street sees only the headline decision in terms of rate hikes or rate cuts, but the Fed’s action on interest rates is more than that.

The 10-year US Treasuries, which is the benchmark interest rate, is also deemed to be the risk-free rate. The value of the US dollar and everything that is priced in the financial market is referenced against the benchmark rate.

This includes borrowing costs for businesses and consumers, which determine investments and consumption decisions.

The 30-year US mortgage rate is one of the most important gauges for the US housing market as higher rates tend to lead to a slump in home prices and demand.

For consumers, interest rates also determine other spending habits, which in particular are important for consumer credit as well as car financing.

The risk-free rate is also a determining factor in the value of the dollar – the higher the rate, the more attractive the US dollar assets are, and vice-versa.

However, there is a tipping point to this theoretical concept.

If the yield on the 10-year US treasuries continues to climb (especially if it goes higher than 5% to 6%), it may also signal a higher risk of default or inability to refinance US debts when they mature.

This will drive the cost of borrowings for the government, especially when the United States is expected to rollover more than US$9 trillion worth of debt papers that are maturing this year.

The FFR is also an important indicator for the valuation of securities or price for financial products which, among others, include corporate bonds, credit default swaps, interbank borrowing/lending, and mortgage- backed securities as well as the valuation of companies.

A wrong move

The Fed is an important institution for not only the US financial markets and economy but the pillar of global finance. Any form of interference will likely see severe repercussions in the form of a major sell-off in assets that are priced in US dollars, starting with the US Treasuries, the dollar and US equities.

This will cause a significant spike in US Treasury yields as non-US residents are likely to offload US Treasuries. Foreigners own some US$8.8 trillion of US Treasuries, which is approximately just over 30% of the total.

Assuming there is a massive exodus by foreigners, the US Treasury yield curve is likely to steepen.

As the US economy is headed towards a high inflationary environment due to the ridiculously high reciprocal tariff rates, the Fed is in no position to cut rates. Instead, it will be under pressure to raise rates due to the expected higher and longer inflationary period, although the economy is headed towards recession.

For foreign bondholders, selling 10-year US Treasuries at a yield of 4.4% to 4.5% makes more sense than waiting for the yields to spike even higher, especially when the United States could issue fresh papers to the tune of more than US$9 trillion this year.

Dollar dumping

Any interference in the running of the Fed will be seen as bad for markets.

US Treasury yield will spike up. The equity market will see renewed selling pressure, especially among foreign investors running for safe-haven assets like gold.

Gold, which is traded in US dollar terms, will resume its uptrend under this scenario.

The dollar index will weaken and this painful adjustment will likely see the United States and the dollar losing their dominant position in the global economy as well as trade.

In summary, President Trump is walking on thin ice when it comes to dealing with the Fed and any move to dismiss Powell will be seen as a black swan event for markets.

Trump’s about turn and comment that he has “no intention” of dismissing Powell is at least positive for now. Let us hope that it stays that way.

After all, the market has more trust in the Fed than the president itself with his flip-flopping policies that have caused the market dearly in terms of value destruction.