Why the Fed chair search matters for the markets

Here's how the market will react if Trump chooses Warsh as next Fed chair

As the Trump administration works toward deciding whether Federal Reserve Chair Janet Yellen will retain her post or be replaced, the average investor could feel the impact of the decision should the president choose to appoint a new chair.

Amid a report Friday morning that Trump met with former Federal Reserve governor and former Morgan Stanley executive Kevin Warsh, who was previously rumored to be a contender for the post, stocks fell slightly before recovering.

The more notable reaction, however, was in the bond market. Treasury bonds saw a considerable sell-off and yields rose, ending higher on the session. This kind of activity would likely continue if Warsh were appointed, said Larry McDonald, head of global macro strategy at ACG Analytics.

Investors could feel the impact of higher interest rates, as right now there is a "very high probability of an interest rate shock impacting stocks," he said.

"We think the market is extremely vulnerable to an interest rate shock. … [if the Fed takes] the punch bowl away, stocks can drop 5 to 10 percent pretty easily," he added Friday on "Trading Nation," referring to the "punch bowl" of the accommodative monetary policy.

More granularly, he said bonds would likely see further downside, as Warsh is seen as more hawkish than dovish. This could theoretically boost bond yields and hurt equities.

Warsh reportedly has friendly ties with Trump already, as his businessman father-in-law is reportedly close to the president.

On Friday, too, it was reported by Dow Jones that the president also met with former Fed governor Jerome "Jay" Powell in recent days regarding the position, though he is not seen as a front-running contender, according to estimates on the PredictIt platform.

In a report to clients Friday afternoon titled "Fed chair search heats up," Deutsche Bank economists Peter Hooper and Matthew Luzzetti dissected different outcomes for Fed chair. They wrote that Yellen's reappointment would "clearly be the one with least disruption to the markets — four more years of the Fed being led under very effective Yellen stewardship."

Warsh, the authors wrote, is "perhaps the most interesting" candidate said to be under consideration.

While in the private sector, he has "not shied from being openly critical of the Fed. His criticisms are often nuanced, making it difficult to draw direct implications for how monetary policy could be different under his leadership, but our sense is that he would come down on the hawkish side of the current leadership," they wrote.

More pointedly, the candidates they believe to have the most realistic probability of being appointed (or reappointed) "suggest the Fed is not likely to be moving significantly in a more dovish direction."