Over-Cooked?

The President says Fed governor Lisa Cook is fired…but are these trumped-up charges?!

Donald Trump’s decision to fire Federal Reserve governor Lisa Cook provided the major talking point over the past week, causing the Treasury curve to continue to steepen. Although it is highly probable that Cook will contest her removal for cause, leading to an eventual hearing in the Supreme Court, there has been a building sense that the White House is starting to prevail over the Federal Reserve, in recent weeks.

This being the case, front end yields have been supported by hopes for more aggressive interest rate reductions in 2026, notwithstanding a growth trajectory next year, which may also take support from tax cuts kicking in, as well as from the benefits of deregulation additionally spurring activity.

As we have previously noted, the current administration believes that cutting rates is imperative to bringing the fiscal deficit down, with Trump’s economic circle broadly dismissive of potential inflation risks this could provoke.

However, markets are more concerned about the threat to price stability should policy be eased too much. Consequently, long-dated yields have failed to benefit as markets build in increased term premia in order to compensate for medium-term inflation risks. That said, the US yield curve is not all that steep on an historical basis.

Moreover, the 2/30 curve in the US remains flatter than is the case in either the Eurozone, Japan or the UK at the current point in time. From this point of view, we think that some of the criticism relating to Trump’s ‘Fed Capture’, or fiscal dominance, may be overstated.

Looking ahead, we would not be too surprised if the next few years see a FOMC that is more inclined to prioritise growth over inflation. This narrative could be supportive for risk assets in the near term, though there could be more of a question mark over valuations, should policy easing in the next 12 months result in the Fed needing to tighten rates more aggressively to control price risks, at a later point in time.

On this basis, we think the US curve does have room to steepen more in the weeks ahead, especially with Powell now signaling a willingness to lower rates, at his address in last week’s Jackson Hole meetings. Notwithstanding this, upcoming data will be key to decision making at the September FOMC. In this context, we could yet see the Fed deliver a cut of 50bps, 25bps or stand pat, depending on the next payrolls and CPI figures.

In France, the decision to call for a Vote of Confidence by Prime Minister Bayrou on 4th September triggered weakness in French asset prices, with the OAT/bund spread widening to 80bps. It has been clear for some time that Bayrou will struggle to pass a Budget this autumn, unless he can garner more support.

Consequently, he appears to have taken fate into his own hands by provoking a sense of crisis, in the hope that this will galvanise a desire to compromise. This feels like a very long shot in our eyes. With the Socialists and National Rally both suggesting that they will vote against Bayrou, there now only seems a very distant possibility that Bayrou is able to prevail and remain as Prime Minister.

In this context, we think that Macron is unlikely to successfully install another technocrat Prime Minister, in order to push through a Budget, without resorting to new Parliamentary elections. Given that National Rally are leading the opinion polls, we could see the party prevail, having fallen short in 2024. Indeed, Macron may even calculate that handing the mandate to the party of the hard right could end up limiting their rise in the 2027 presidential elections, should the party struggle to deliver on many of the promises it has been seeking to make to its voters.

This political upheaval may weigh on French spreads, and were a non-centrist Prime Minister to be elected in the next several months, we could see OAT spreads widen to around 100bps, reflecting the medium-term political uncertainty. However, the limits on Parliamentary power in France should help limit any potential volatility, unless investors see a very clear read through of what is likely to pass, in the Presidential elections in 2027.

Of course, it is always possible that Macron himself may decide that he wants to call an early Presidential election, in the hope that a sense of crisis could help avert the trend of voters moving towards more radical political extremes. That said, having seen how badly his decision to call early Parliamentary elections worked for him last year, you would tend to think that this will make Macron much more reticent.

Fundamentally speaking, the big challenge that France faces as a country is that its citizens feel a sense of entitlement to a standard of living and a way of life that they see as their birthright, yet seem unwilling to work hard enough in order to pay for this.

For a number of years, this has meant that France has been living beyond its means but has shown little appetite for change. Debt levels have continued to climb steadily over the past couple of decades and with the deficit around 5.5% and France subject to Eurozone excessive deficit procedures, there is now an imperative to deliver greater fiscal responsibility.

Yet if society continues to resist change at every turn, so it seems that there is a building case of an irresistible force meeting a seemingly unmovable object. For these reasons, we have positioned structurally short of French assets and will be watchful for how the current chapter in a slowly building crisis unfolds.

Across the Channel, gilts have had another bad week, adding pressure on the Labour government as they consider their options with respect to the upcoming Budget. As highlighted previously, markets are concluding that simply raising taxes from already elevated levels will only harm growth, add to inflation, and may do little to close the fiscal black hole.

Therefore, unless the government can demonstrate it can successfully curb runaway welfare spending, it runs the risk of losing market confidence. Meanwhile, as yields edge upwards, so the country comes closer to the ‘event horizon’ beyond which the gravitational pull from the growing black hole in the government’s finances end up creating a moment when it becomes difficult to turn things around without something breaking in a more profound way.

Thus, we think it is increasingly urgent that the Bank of England ceases QT sales of long-dated government bonds and the DMO ceases issuance, in order to provide much needed technical relief, to buy the government more time.

European credit spreads have widened over the past week, weighed down by moves in France. Some optimism with respect to Eurozone growth also seems to be starting to wane, denting regional optimism.

That said, ongoing demand for corporate bonds has helped to limit spread volatility over the summer and this trend appears to remain prevalent for the time being. However, we can see how rising net supply in September could come at a time when volatility picks up and this could see some retracement wider in spreads.

In FX, the euro has also underperformed over the past week, with the dollar making broad based gains, despite concerns with respect to Fed independence and fiscal dominance. Investor positioning has been overweight in the euro and, in part, these moves may represent some risk reduction. We still remain inclined to think that dollar strength may be short-lived and we stay inclined to look for opportunities to add to short positions in the greenback.

Looking ahead

In the coming week, the US Labour Day holiday means that September may get off to a quiet start. However, the coming month is set to be an active one, with the Fed very much in focus. Reflecting on the Cook firing, it has been pointed out that governors including Robert Kaplan and Richard Clarida both resigned under Biden, on allegations of wrongdoing with respect to personal trading.

In this respect, it may be surprising that Lisa Cook has decided to stay on in her role, notwithstanding the allegations levelled against her, even if some might think these are trumped-up charges that have been overcooked. It is also tempting to conclude that the Biden appointee would not have found herself in the crosshairs, had her position on monetary policy aligned more closely to that of the White House.

More broadly speaking, the administration knows that it has to tread carefully on the topic of Fed independence. However, it will also be quick to highlight that, with respect to policy, even a fully independent Fed has still managed to make a significant number of policy mistakes over recent years.

Perhaps central bank independence has been idolised too much (??). But more importantly, Trump is a President who has become accustomed to getting his own way. When it comes to interest rate policy, there can be no mistaking what he wants.