The One Fed Choice That Would Really Spook The Bond Market

Dan Fuss Says Market Most Comfortable With Yellen

In the eyes of Rick Rieder, the global chief investment officer of fixed-income at BlackRock Inc., the bond market knows that the Federal Reserve is bigger than just one person.

Unless that person happens to be John Taylor.

John Taylor

Photographer: Andrew Harrer/Bloomberg

As speculation swirls about whom President Donald Trump will pick as Fed chair, traders in the $14.1 trillion Treasuries market can take comfort knowing the next leader will likely follow through on Janet Yellen’s plan to gradually raise interest rates and trim the central bank’s $4.5 trillion balance sheet. To Rieder, that even includes Kevin Warsh, seen by some as one of the more hawkish on the president’s short-list. That helps explain why benchmark 10-year yields are near their 2017 average, even after rising the past three weeks, while rates on shorter maturities grind higher.

One wild card for markets who’s still in the running, though, is Taylor, the Stanford University economist known for the monetary-policy rule that bears his name. He’s viewed as a long shot by betting website PredictIt, but is believed to still be under consideration, according to two people familiar with the matter.

“I’d say today, the markets are expecting that he’s probably not going to be the candidate, but yes, you could see the markets react to that,” Rieder said. He expects 10-year yields to climb to 2.5 percent to 2.75 percent by year-end, from 2.35 percent now, and that’d likely happen even sooner with a Taylor nomination. By contrast, the reaction would be “muted” in the near-term if someone else on Trump’s short-list gets the nod, he said.

The Taylor Rule estimate for the fed funds rate incorporates factors such as the neutral real rate, inflation and unemployment. The baseline model projects 3.5 percent, compared with the current 1.16 percent effective rate.

The two-year U.S. yield, at 1.49 percent, isn’t significantly higher than the fed funds rate. Taylor taking over, and potentially accelerating the pace of rate hikes, could quickly alter that thinking.

Taylor’s “polar opposite,” according to Stephen Stanley at Amherst Pierpont Securities, is Neel Kashkari. The Minneapolis Fed president said this week that the central bank should stop raising rates until the core personal consumption expenditure index reaches 2 percent, something it hasn’t done since 2012. 

While there’s little indication that Kashkari is under consideration, he has gained traction in betting markets, jumping to fifth place, just behind National Economic Council Director Gary Cohn, after DoubleLine Capital Chief Executive Jeffrey Gundlach predicted he’d take over the chair position.

Still, it’s Taylor who has emerged as the most plausible candidate from outside the Fed or Trump’s inner circle. And he’s the most likely to jolt markets, given his rules-based approach.

“Where the market is priced right now is a lot closer to Kashkari’s view than Taylor’s,” Stanley said. “That’s just the market being more dovish than the Fed itself.”

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