Pricing ‘new brooms’ at White House and Fed

October 24, 2012

With less than two weeks left to the U.S. presidential elections and all three televised debates done and dusted, investors are at last squaring up to the detailed financial market impact of the event itself and the column inches in newsprint and research reports lengthen by the day.

Barclays interest rate strategists are one of the first to stick hard numbers on likely market outcomes in a report late Tuesday that dug deep into both the well-documented “fiscal cliff” but also into the less discussed uncertainty surrounding the medium-term direction of the Federal Reserve and its leadership.

With news reports suggesting Fed chief Ben Bernanke will not now choose to stand again for a third term at the helm of the U.S. central bank in 2014, some may argue Fed risk from the election has been neutered. But with monetary policy still the only game in town policy-wise for many asset managers – at least on the stimulus side — then even the slightest risk to the Fed’s mandate remains a significant market factor.

Even though it figured almost nowhere in the big public debates, Republican challenger Mitt Romney has vowed that if elected he would not renominate Bernanke to a third term.  Romney’s running mate Paul Ryan is an even harsher critic of the Fed, backing legislation that would open up the Fed’s monetary-policy decisions to congressional scrutiny and strip the central bank of its mission to seek full employment. Given that the longevity of the Fed’s third and current round of asset purchases is tied explicitly to cutting the jobless rate, that’s a particularly controversial stance going forward.

The Barlcays strategists, as a result, reckon that if Romney were elected, a more hawkish Fed over time would be more likely than under a re-elected administration of Democrat Barack Obama.  And they said it’s possible that Fed funds futures market could see implied Fed interest rates for the end of 2015 jump by as much as 50bp in a knee-jerk reaction to a Romney win and drop 20bp on an Obama victory. (According to Reuters data, September 2015 Fed funds futures are currently implying a rate of 0.60% — compared to the current target of 0-0.25% range — and that has risen about 10bp since the first presidential debate on Oct 3 saw Romney’s opinion poll ratings rise to match and in some cases nudge ahead of Obama’s.)

Any new Fed chairman after January 2014 in a Romney presidency is likely to be more hawkish than under an Obama presidency. Still, changes would likely be gradual, as a new chair will still need the support of the FOMC, and the Fed is unlikely to change course drastically for fear of losing credibility.

The Barclays team reckons that while Fed policy would continue to be driven by Bernanke until his latest term expires early in 2014,  the White House choice for the new Fed president would have to be revealed next summer and a Romney win next month would therefore “undoubtedly start to pull forward rate hike expectations.” As a result they sketch out how the Fed’s “reaction function” would alter under different candidates to succeed Bernanke — supposing current Fed vice-chair Janet Yellen would be the Obama choice and possible Republican candidates would be either Romney adviser Greg Mankiw or Stanford economist John Taylor .

Ironically perhaps, they use Taylor’s eponymous “rule” on how central banks should set interest rates — shown as  Fed funds rate = 4% + A * (inflation – 2%) + B * (5.6- unemployment rate), where A and B are coefficients that describe how responsive the funds rate should be to either inflation or unemployment.

Barclays reckons there’s little debate on how responsive the rate should be to inflation (with all broadly agreeing on a coefficient of about 1.5)  but there’s considerable difference on how candidates see the impact of unemployment on setting the rate. It said that while Yellen prefers an unemployment rate coefficient of 2.3, Taylor uses just 1.15 and Mankiw has espoused 1.4. All this matters of course in figuring out how the Fed would react to changes in the labour market. Crunching the numbers, it reckoned the difference of view could mean the desired Fed funds rate at the end of 2015 could vary by up to 100bp depending on whether you take the Yellen or Mankiw view and a further 50bp under the original Taylor rule assumption.

The economists however pick three reasons why those readings, taken largely from the 1990s,  may not be as extreme in the current environment: 1)  The extreme nature of the zero interest rate floor and quantitative easing may change the view 2) the Fed looks at a broader range of labour market indicators beyond simply the unemployment rate and 3) any new Fed chair would need to gain the support of the Fed’s Open Market Committee.

One way to estimate how much Fed fund expectations could be repriced following a Romney win is to look at what the market was pricing in when the Fed extended its rate guidance to late-2014 (ie, following the January 2012 FOMC meeting). This would imply a reversal of the latest Fed initiative of extending the guidance to mid-2015 and its pledge to keep policy accommodative for a considerable time even after the recovery strengthens.

They conclude:

In all, a 50bp repricing of fed funds expectations 3-4 years out as a knee-jerk reaction to a Romney win is possible.

For the record, they think Obama is more likely to go off the fiscal cliff if elected — at least temporarily — and a repricing of the resultant growth hit could sink 10-year Treasury yields to 1.5% or below.  Conversely, a Romney win could lead to 10-year yields at 2.0% or higher.

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