As we said yesterday, the race for the next Federal Reserve chair took another step forward this week as President Trump revealed his list of five finalists and said he would make an announcement by Nov. 3. While it is fun to speculate about whom Trump will pick, what matters for trading is how each pick will shape policy. I think the market is being overly simplistic in its thinking about the range of possibilities, and from this stem a few trades worth considering.
The Myth of Trump the Dove
President Trump has made a couple of offhand comments about preferring low interest rates. But he has said a lot of things. He said no one would lose their health coverage, he would spend $1 trillion on infrastructure, there would be no net tax cut to the wealthy, etc. These are all things he said formally, yet it seems he doesn't feel compelled to follow any of them. Why do we put so much faith in this off-the-cuff comment about interest rates?
Like all of us, actions speak louder than words. Trump has nominated Randal Quarles to the Fed board, and he is definitely not a dove. He also appears likely to nominate Marvin Goodfriend to another board seat. Goodfriend has endorsed the same Fed Oversight, Reform and Modernization Act that Fed chair finalist John Taylor did. Moreover, if Trump viewed low interest rates as a litmus test, why would he even be talking to people like Kevin Warsh or Taylor for the Fed chair? I'm sure Taylor laid out his vision in the interview with Trump last week, and Trump was still impressed.
All this adds up to a simple conclusion: Trump isn't a low interest rate guy.
Why Doesn't the Market Believe the Fed?
Let's get back to the dichotomy between what the Fed's dot plot says and what the market has priced in, because I think it is illuminating on what finalists Gary Cohn and Jay Powell might be like as Fed chair. Why does the market doubt the Fed will follow through on hiking four to five times over the next 15 months or so? Because the market doesn't believe the Fed's inflation forecast. TIPS are pricing in 1.45% inflation over the next two years vs. a Fed forecast of almost 2%. Implicitly, the market is saying the Fed will back off rate hikes if its inflation forecast doesn't come to pass.
That might be true if current Fed Chair Janet Yellen or another economist becomes chair. Neither Cohn nor Powell is an economist. They are finance guys. The idea that 1.5% inflation is too low is one that is held by many (probably most) Ph.D. economists, but not widely held outside of academia. I don't believe a chair from the world of finance will view inflation the same way the current Fed does.
Where Does This Leave Us?
- Taylor and Warsh: I'm highly confident they will be much more hawkish than the current Fed. I'd guess market expectations for short-term rates need to come up by 75-100 basis points in 2018.
- Cohn and Powell: probably marginally more hawkish than current, at least if judged by what the market has currently discounted. I think they are worth one to two more hikes between now and '18 than the market is currently assuming.
- Yellen: would likely want to follow around where the dots are, but is probably the candidate most likely to slow down if inflation slowed.
- Warsh, Cohn and perhaps Powell: more likely to view movement in stocks and credit markets as important inputs in setting policy. Notably, this might mean they are more likely to stay hawkish for now as valuations are stretched in various risk markets.
How Would the Market React to a More Hawkish Fed?
Putting it all together, I believe the market has priced in easier monetary policy than is likely in almost any scenario. There are only two ways the Fed's path is this low: either because a recession comes near-term (definitely not what the market is expecting based on stock valuation) or inflation dips even lower than it is now and Yellen remains as chair.
So what does this mean for markets and how can we trade it?
- Go long the dollar. If short-term interest rates are higher and inflation lower, the dollar should benefit. I'm using the U.S. Dollar Bullish Fund (USDU) to express this view, which gives you exposure to the dollar vs. a broad basket of other currencies. I also kind of like shorting the euro vs. the dollar, as I think people are also a bit too confident in the European Central Bank's next move, but I think you have more outs in something like USDU.
- Short TIPS vs. nominal bonds. This is a good trade in theory, but I don't actually have it on for a few reasons. First, the market is already pricing in pretty low inflation. I'd guess only a Warsh or Taylor Fed would get it to move a lot lower. Second, I do think a fourth-quarter rebound in inflation is more likely than not, which could interfere with this trade working short term. Lastly, the return you get isn't enough to want to keep the trade on intermediate term. If you did this trade with 10-year bonds, you'd need a 0.25% decline in inflation expectations to get just a 2% return. I think the currency trade gets you more bang for your buck plus has more outs.
- Short five-year Treasuries outright. I have this trade on using five-year futures, but bear in mind that since I'm a bond manager, I'm always net long bonds, so what I'm actually doing professionally is more like an underweight. Regardless, the five-year part of the curve is the best place to short if you want to bet on the Fed being tighter over the intermediate term. However, I don't think it is quite as good of a trade as...
- Pair trade 20- to 30-year bonds vs. two- to five-year bonds. I'm doing this by buying Long Bond and Ultra Long futures and shorting five-year futures while being severely underweight two- to three-year bonds vs. my index. This should pay off in both directions if tighter policy causes a recession, but the net of it pays off as long as the Fed keeps hiking, which as I said above, I think is likely no matter who becomes chair.
(This commentary originally appeared on Real Money Pro at 7 a.m. ET today. Click here to learn about this dynamic market information service for active traders.)