Donald Trump may look to install another dovish chair of the Federal Reserve next year to replace the incumbent Janet Yellen despite expectations to the contrary, according to fund managers. 
In March the Federal Open Market Committee (FOMC) raised the target range for the federal funds rate from 0.75 per cent to 1 per cent with more hikes expected later this year.
However, comments made by Yellen after the rise suggested she was in no rush to raise rates as fast as some had anticipated and some analysts have revised down their forecasts from four rate rises to three this year.
Indeed, the CME Group’s ‘Fedwatch’ tool, which measures the likelihood of Federal Reserve rate rises, suggests a 68.3 per cent chance that there will be between two and three rate hikes this year, as the below graph shows.
Interest rate level probabilities at FOMC meeting on 31 January 2018
Source: CME Group
US president Donald Trump was critical of Yellen and the Fed on the campaign trail and with five Federal Reserve spaces to be filled over the next 18 months, including both chair and vice-chair positions, many expect more hawkish members to be added.
Yet, after nearly 100 days in the White House, Fidelity multi-asset portfolio manager Bill McQuaker says Trump may be looking to the Fed as a ‘lever’ to implement US economic growth as he struggles to follow through on his own policies.
“Donald Trump was elected president on 8 November last year and I think there would have been a period measured in days or weeks where he genuinely thought he was the cleverest man in the world,” he said.
“I mean that literally because he is someone who was told all the way through his election campaign that he didn’t stand a chance and in his own party people were disowning him weeks before the election so I suspect he felt very clever and very vindicated.
“Fast forward four months and he’s getting towards the end of his [first] 100 days as president and rather than feeling like the cleverest man in the world I wonder whether he is feeling like the most frustrated man in the world.”
In recent months, both the controversial travel ban and his American Health Care act have been rejected by the justice department and congress respectively and as such the president is moving on begrudgingly to tax reform.
“It must be dawning on him that getting stuff done, even with his legendary deal-making skills, is a lot tougher than I suspect he thought it was going to be,” McQuaker said.
“At the heart of his problem with tax reform is that many of the same people who didn’t like his [American Health Care] repeal and replace act won’t like his tax reform ideas either because they involve increasing the national debt.
“These individuals will quite happily sign off on lower taxes but they have to be lower taxes that are funded by spending cuts elsewhere.”
McQuaker notes that the proposed border adjustment tax would provide a large amount of revenue to the government and adhere to Trump’s protectionist policies, but would also harm US importers as well as force up prices, leading to higher inflation.
“If he went for tax cuts using the border adjustment tax to make the revenues to make the cuts, I think that will be dead on arrival as well,” the manager said.
“The frustration comes from the fact that he’s got all of these things that he wants to do and it is proving very difficult to do them.”
However, McQuaker says the Federal Reserve faces less scrutiny than the government and is largely allowed to conduct business without the same oversight.
“Now this is where the Federal Reserve come in. The Fed is famously not subject to the same checks and balances that characterise most of the US system,” he said.
“To my mind I think Trump will look at the Fed and one of the things he must ask himself is ‘is that going to be our most important tool for making the economic changes that we want to make to increase or raise the rate of growth in the US economy’ because the other stuff is proving to be hard to pull off.
“If you have a Fed that is prioritising the same thing as you then they can push on in a way that the president can’t.
“If there is some sense in what I have just laid out then why would he appoint a hardliner whose first act one might think would be to raise interest rates, slow the US economy, harden the US dollar and make it harder on US exporters?
“Would it not be more sensible from the point of view of achieving the aims of the president to either reappoint Yellen – uber-dove that she is?”
He added: “The market either believes we will get someone who is a little bit more hawkish or the risk scenario is someone who is a lot more hawkish and I think we need another risk scenario which is someone who is more dovish which would be quite surprising.”
Under the current, more dovish Fed, the US has experienced steadily increasing inflation while the US dollar has rallied to five-year highs, as the below graph shows.
Performance of US dollar over 5yrs
Source: FE Analytics
With low interest rates, consumers have been induced to spend, causing the economy to grow and inflation to increase while the opposite holds true for rising interest rates.
Paul Brain, head of fixed income at Newton Investment Management, says that there is no clarity on rate increases as yet, but agrees that a dovish chair is more likely than some are predicting.
“That being said, a Trump-influenced Fed is likely to be more pro-growth and would therefore slow the pace of interest rate increases,” he explained. “This is despite the comments he made prior to the election when he suggested the Fed had created issues for the economy by keeping rates too low.
“Now he is elected he needs to prove he can keep the economic momentum going and is likely, at the margin, to apply pressure on the Fed to slow the pace of rate increases.”
However, Ariel Bezalel, fixed income manager at Jupiter, believes there are other more pressing concerns for investors to worry about before then.
“Given the Fed mandates of price stability and maximising employment, we prefer to focus on how the Fed would likely react to the evolution of the macro environment, i.e. the fundamentals,” he said.
“In this regard, we believe that the markets, including fixed income, is anticipating a perfect execution of the programme that Trump has been communicating on.
“For example, we believe that there is downside risk to the rapid and effective implementation of the fiscal stimulus: tax cuts and other infrastructure spending.
“Of late it’s worth highlighting that some of the data coming out would indicate some weakness ahead in the US economy.
“Namely, the latest Federal Reserve senior loan officer survey indicates that banks have been tightening lending standards and credit volumes have been shrinking, especially in the consumer segment. This is somewhat worrisome and worth monitoring going forward.
Net Percentage of Domestic Banks Tightening Standards for Commercial and Industrial Loans to Large and Middle-Market Firms
Source: Board of Governors of the Federal Reserve System, fred.stlouisfed.org
“In light of the above, given the current levels of US Treasuries and the sell-off seen since last August we currently see value in longer (10 years plus) part of the curve.”