US prosecutors have reportedly launched a criminal investigation into Fed chair Jerome Powell over a US$2.5bn renovation of the Fed’s headquarters in Washington. Powell has responded by warning that the probe is an attempt to rein in the Fed’s independence and to pressure it into lowering interest rates. This signalled resolve and tells markets the Fed will not go quietly.
My feeling is that markets have read all of this correctly. The immediate reaction so far - an increase in the gold price, a softer dollar, and an uneasy reaction on risk - is textbook. When institutional independence is questioned, investors reach for assets without the risk. Gold moved first for a reason, aided by wider geopolitics.
Two paths from here
One option now is further escalation. The probability of this is low, but the risk is significant.
In this world the dollar weakens structurally. Rates volatility rises as term premia reprice, bringing outright yield curve control (YCC) closer. Equities carry a political risk tax and gold stays bid.
Nobody wins, as the cost of capital rises and policy transmission breaks.
The alternative is what I would call the ‘fade’, and it is the base case.
Under this scenario the story loses steam. No charges have been filed. With only months left in Powell’s chair term, the upside to escalation is limited and the downside of market instability is real.
Markets stabilise but they do not forget
The bigger issue is the post-Powell Fed. Even if this episode fades somewhat, the damage is not zero. Future Fed leadership will be perceived as significantly more exposed. That points toward a more fiscally dominated policy mix: looser tolerance for inflation; less pre-emptive tightening; more political constraint.
That regime is good for gold (our Strategic Asset Allocation (SAA) based view); bad for the dollar (another SAA based view); volatile for long rates until YCC comes in.
Which, notably, is exactly how markets began to trade in the immediate aftermath of the news from Powell.
Bottom line
We believe the most likely outcome is de-escalation in the short term especially if the market reaction gets worse from here. But the independence premium has taken a hit and once markets start pricing that risk, they rarely give it back quickly. Fed policy will now be expected to be on hold till Powell moves away - events solidify this as the world’s biggest central bank will not want to show that it is bending to external pressure. Additional cuts, however, are likely to come through once the new Chair is in.
