Musical Chairs at the Federal Reserve and Interest Rate Volatility

 

The Federal Reserve (Fed) has been a constant pillar of stability throughout the recent economic crisis. As we near the removal of crisis accommodation (tapering Quantitative Easing), the Fed is also undergoing upheaval and transformation. The Biden administration has the opportunity in the near future to shift the makeup of the Board of Governors from a Republican majority to leaning Democratic. Additionally, what seemed like a high probability of Powell being renominated for the Chair is now less certain. The looming question for the market is whether or not Powell will have a chair when the music stops?

The current Board of Governors has five Republicans and one Democrat with one vacant seat to fill. Randy Quarles (Republican), the Vice Chair of Supervision, will see his Chair term expire in October. Quarles’ term as Governor expires in 2032 but it is undetermined if he will leave in October. Richard Clarida’s (Republican) term as Governor expires in January 2022 and Powell’s (Republican) term as Fed Chair expires in February 2022. This opens the door for President Biden to utilize his lone Democrat Lael Brainard to either replace Powell as the Fed Chair or Quarles as the Vice Chair of Supervision. Depending on Biden’s first move, he may have up to four seats to fill.

As of this week, Boston Fed President Eric Rosengren (hawk/voting member in 2022) and Dallas Fed President Robert Kaplan (hawk/voting member in 2023) both resigned due to criticism around their personal trading during the pandemic. The resignations, in combination with the possible changes at the Board of Governors level, allude to 1) a potential shift to a Democratic majority within the Board of Governors and 2) an overall dovish leaning Federal Reserve. This suggests that the timing and speed of rate hikes may be more conservative than both the Dot Plot and the market are expecting.

We believe this uncertainty is one of the reasons for the recent spate of volatility in the bond market and could be a source of volatility on the horizon.

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Reminders from the last Taper – Volatility

Looking back at Yellen’s term – the Fed decided to taper asset purchases followed by raising the Fed Funds Rate in a short period of time – we saw the 30-yr rally throughout tapering and then sell-off as we neared the first rate hike. The same trend occurred post the first rate hike as the market prepared for additional rate hikes (sell-off). Each period saw the 30-yr U.S. Treasury move by over 100 bps within a short timeframe.

 

30-yr U.S. Treasury vs. Fed Funds

Source: Bloomberg September 29, 2021

 

Additionally, the Fed’s dovish leaning nature registered a historically slow tightening cycle as the “dovish” Yellen-led Fed waited one year between initial liftoff and the eventual path towards the terminal rate. In the end, the handoff to Powell marked a lower terminal rate due to market volatility. We were reminded of the market’s need for accommodative monetary policy during this period of time.

 

Fed Dot Plot vs. Market Expectations

Source: Bloomberg September 29, 2021

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Bottom line:

The Fed is transitioning from a source of stability throughout the pandemic to a source of volatility. The combination of removing accommodation (tapering), the uncertainty within the Board of Governors and Fed Chair position, and the potential for a dovish leaning Fed moving forward suggest not only unintended market disruption and volatility but also a slower tightening cycle ahead.

 

 

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