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Trump's unusual style of picking a Fed chair has created a more volatile bond market

  • The bond market is pricing in some odds that John Taylor, the Stanford economist, will be the next Fed chair.
  • Yields rose after reports that President Trump took a straw poll of Senate leaders that showed they favor Taylor, the most hawkish candidate in the running.
  • Taylor's rules-based approach to raising interest rates has made the market view him as someone who could put the Fed on a quicker interest-rate-hiking path.
John Taylor, professor of economics at Stanford University
Tom Williams | CQ Roll Call | Getty Images
John Taylor, professor of economics at Stanford University

The bond market is taking Stanford University economist John Taylor very seriously as a candidate to chair the Federal Reserve.

Taylor is seen as the most hawkish pick, and the candidate most likely to set the Fed on a faster course for raising interest rates, potentially upending the current policy of a slow-paced normalization of interest rates.

Fed governor Jerome Powell has been reported to be the front runner in the White House, but the fact that Taylor moved up the list last week and was mentioned as a candidate by the president has kept him in the running, right after Powell. Taylor got another boost in the market's eyes when the GOP Senate leadership favored him in a show of hands after President Donald Trump asked them who they liked for the job.

That endorsement by the senators triggered a slight move higher in yields, which have been creeping up. "This move in rates is people getting defensive around what people view as someone who is much more hawkish. We can debate if he's more hawkish or not, but the market's view will drive the day. It prices it in first and asks questions later," said George Goncalves, head of rates strategy at Nomura.

Goncalves said seven to 10 basis points of the recent run up in 2-year yields could be attributed to the speculation about Taylor, but that would be a third to a half of what the initial move would be if he were nominated. "Then there would be a part two. If he gets nominated most likely he's not going to speak up right away and say 'I'm not the hawkish guy you think I am," said Goncalves.

Kevin Warsh, a former Fed governor, had been leading the pack several weeks ago on PredictIt, an online probabilities market. But Warsh now seems to have fallen back, even behind Fed Chair Janet Yellen, who is seen as the third most likely candidate.

"The odds on Taylor are sufficiently high, that there will be some 'it's not Taylor impact' if Powell or Yellen are chosen as the next Fed chair. The sharpest reaction will be if Taylor is chosen," wrote Alan Ruskin, head of G-10 currency strategy at Deutsche Bank.

Taylor is well known for the monetary policy rule that's named for him. If the Fed adopted his Taylor rule, it would have a framework using strict rules for raising interest rates, which appeals to some lawmakers who have complained about the Fed for not being accountable on how it decides policy.

Taylor's "rule" currently indicates the Fed's policy rate should be as high as 3.5 percent, but some economists argue that Taylor would see the lack of inflation and a low real rate of return that would instead suggest a much lower rate.

But that's not how the bond market views him. Besides the 2-year, the 10-year yield moved higher Tuesday and tested the important 2.42 percent level before falling back slightly.

"The part I'm struggling with is it's so inconsistent with what [Trump's] lean is right now," said Goncalves of the idea that Taylor could be Trump's choice. "The president has been very vocal about the fact that he's a low rates person."

Stocks have basically ignored the horse race, but one bond strategist said Trump has brought volatility back into the market with his public commentary on the Fed nomination process.

"It's unconventional, I think. I don't think this is the way it's been done in the past," said Goncalves.

The dollar has also not been as sensitive as yields to each candidate, but it could move if he were named. The bond market could see a dramatic repricing of interest rate expectations, and that could send the dollar higher and hurt stocks.

Powell is seen as only slightly more hawkish than Yellen and as someone who would follow the Fed's basic path. The Fed has forecast three rate hikes for next year, but the market is only pricing in just one.

"My sense is many people are talking like it's a choice between Taylor and Powell. Maybe it's not. Maybe you get both of them. Powell gets chair because he's been there longer, and Taylor gets vice chair. I would expect something like that," said Marc Chandler, head of foreign exchange strategy at Brown Brothers Harriman.