How Trump firing Powell could backfire and lift interest rates

President Trump continues to exert pressure on Federal Reserve Chair Jerome Powell for significant interest rate cuts, despite denying immediate plans for his dismissal. However, Wall Street firms, including JPMorgan and Deutsche Bank, warn that removing Powell would likely have the paradoxical effect of driving long-term interest rates higher. This is attributed to concerns over a perceived loss of Fed independence, which could fuel inflation expectations and demand greater compensation for inflation risks. Market reactions during a brief period of elevated ouster probability saw 10-year Treasury yields climb 5bps and 30-year yields rise 11bps, underscoring the potential for substantial spikes in longer-term rates and significant dollar depreciation, negatively impacting economic activity and fiscal stability should such an event occur.

Analysis

Significant political pressure on the Federal Reserve is creating policy uncertainty with paradoxical market implications. Despite President Trump's desire for lower interest rates, analysis from major financial institutions, including JPMorgan and Deutsche Bank, indicates that an attempt to oust Chairman Jerome Powell would likely have the opposite effect on long-term rates. The rationale is that such a move would undermine the central bank's independence, elevating inflation expectations and risk premiums. Consequently, investors would demand greater compensation, pushing long-term yields higher, which would weigh on economic activity and worsen the U.S. fiscal position. This is not merely theoretical; a brief period where the probability of Powell's removal increased saw a tangible market reaction, with 10-year Treasury yields climbing 5 basis points and 30-year yields rising 11 basis points, while 2-year yields fell 5 basis points. Extrapolating from this event, Deutsche Bank estimates that an actual dismissal could trigger a 20 basis point spike in 10-year yields, a 45 basis point rise in 30-year yields, and a nearly 6% decline in the U.S. dollar, effectively reversing the year-to-date decline in Treasury yields and introducing significant volatility.

Key Decisions for Investors

• Investors should be cautious of a sharp sell-off in long-duration U.S. Treasury bonds, as any escalation in political pressure on the Fed could trigger a rapid increase in long-term yields.
• Given the estimated 6% potential drop in the U.S. dollar, it may be prudent to review and hedge significant USD exposure against currency volatility.
• Monitor political rhetoric concerning the Fed's leadership as a key event risk, as it could lead to a bear steepening of the yield curve, with short-term rates falling while long-term rates rise, impacting fixed-income portfolio construction.
• Consider reducing exposure to rate-sensitive sectors of the economy, as a spike in benchmark long-term rates would likely increase borrowing costs and negatively impact the outlook for economic activity.