Hot Topic: Should central banks be independent?

Market Analysis /
Axi Team / 14 Jan 2019

There’s no escaping the fact that that Donald Trump hasn’t been holding back in his criticism of the Federal Reserve’s stance over monetary policy. With four interest rate hikes in 2018 and a further two currently expected in the year ahead, the return to ‘normal’ borrowing costs after a decade of cheap money is having a profound effect on many corners of the market. Consumer demand is slowing, businesses are less willing to borrow to fund expansion and equities start to look a little less attractive when compared to the risk free returns of government debt. On top of all this, the prospect of meaningful yields on dollar deposits is pushing up the value of the greenback, making life significantly more challenging for US exporters.

That set of affairs doesn’t sit well with Donald Trump, despite Powell having navigated the economy to an enviable position where inflation is close to target and practically every American who wants to work has a job. What’s more, Powell was Trump’s nomination for the job after Janet Yellen’s term expired in February 2018, but with the President threatening to fire the Fed chief, what does that mean for markets?

Historically, central banks weren’t independent of government, but rampant inflation in the 1960’s and 1970’s saw many campaign to set the agenda free of political influence. This was arguably ideal as it enabled a longer-term view to be taken, going well beyond the next round of elections, and provide a more prudent approach to be taken.

If we do see Donald Trump move to replace Jerome Powell, presumably it would be with someone who would advocate lower interest rates, so any suggestion this will happen has the potential to result in three key market movements.

  1. Gains for US indices. Higher interest rates are deterring investment, shifting cash into government debt rather than more risky equities. The prospect of lower rates should see cash transferred back between these two assets. The DOW may manage to steer clear of a dip into bear market territory as a result.
  2. US Treasuries rally. Investors would bid up the price of government debt, meaning that the corresponding yields would fall.
  3. Dollar weakness. Lower yields on government debt makes holding Dollar denominated debt a less attractive proposition. Investors hunting out yield would in theory therefore switch into other currencies such as the Euro or Yen. This would also play to Trump’s export agenda, making US manufactured goods that bit cheaper. Shorting any dollar cross could therefore prove profitable.

But this is far from a risk-free gambit. Recent political intervention in central banks hasn’t been well received at all. The governor of the Reserve Bank of India quit his post after politicians intervened regarding the use of regulatory capital, whilst the Turkish President’s move to put his son-in-law in charge of economic policy has proved ‘challenging’ for the Lira.

A move to defy traditional schools of economic thought and push interest rates lower whilst the economy is expanding could have two key consequences.

  1. Inflation would soar, as consumers would have little incentive to save. This would be accompanied by marked dollar depreciation, providing opportunities to short any dollar cross.
  2. Global panic over political interference in US financial markets could lead to a flight to safety, depressing valuations of most US Dollar denominated assets – and making it a lot more expensive for the US to service its growing debt pile. Instruments like gold however would likely prove incredibly popular in such circumstances.  

What we have learnt over the last two years is that Donald Trump is more than willing to push boundaries for short term gain. The tax breaks allowing US companies to repatriate cash held overseas drove a sharp rally for both the stock market and the economy as a whole, but this stimulus is already proving short lived. With a President who a times appears willing to see himself judged on little more than the performance of Wall Street, it’s perfectly believable that he could look to have Jerome Powell replaced with someone more willing to reflect his own views. That would come at a price – dollar depreciation and rampant inflation – but it would have the potential to generate some attractive trading opportunities, too.

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