If history is any guide, bond traders will be in for a volatile few days if Kevin Warsh is selected as the next leader of the Federal Reserve.
Or, it’ll be smooth sailing in the $14.1 trillion Treasuries market if President Donald Trump taps Jerome Powell or Janet Yellen.
Strategists at Nomura give each scenario 40 percent odds. But while a Powell or Yellen nomination would nudge two-year Treasury yields lower by only two basis points in the following week, Warsh, seen as the front-runner, would spur a 15 basis-point increase, the steepest climb since early March.
And the benchmark 10-year yield would jump 10 basis points, pushing it closer to Nomura’s 2.6 percent year-end target, from about 2.36 percent now.
“Future moves will be a function of continuity or a major shift,” Nomura strategists led by George Goncalves wrote in a report dated Oct. 6. “We view the change in Fed leadership as another critical piece in the puzzle needed for our bearish call to continue, where in many respects we are banking on Warsh to push U.S. rates up.”
One key to handicapping market reaction, the strategists say, is looking back at changes in Fed leadership over the past four decades. In the case of Paul Volcker in 1979, he ushered in rapid rate hikes to tame accelerating inflation, with Treasuries not fully pricing in the impending pain. With Ben S. Bernanke in 2005 and Yellen in 2013, by contrast, there was limited movement in yields in response to their nomination, in part because of the perception of continuity.
Warsh would represent the biggest change in course from the current Fed, according to Nomura. For starters, he’d be less likely to view a declining stock market as a reason to stop tightening policy. That could mean the end of financial conditions remaining near the easiest in decades.
“Warsh could end up being modern-day Volcker when it comes to arresting FCI,” Goncalves wrote. They also see the Fed’s balance-sheet unwind as more likely to stay in place for longer under Warsh’s leadership.
Powell, on the other hand, would be the closest thing to a “Yellen proxy,” and 10-year yields would fall only about three basis points in the week after his nomination, the most muted reaction Nomura expects for those on Trump’s short-list. The choice might give Trump, who’s repeatedly pointed to stock markets setting new records during his term, a sense that he changed something, without dramatically altering the central bank’s course, in Nomura’s view.
“That he’s a Republican with Fed experience would strongly count in his favor,” Goncalves wrote. “But, we think a Powell Fed would be viewed as business as usual.”
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