Are markets pricing in the threat to Fed independence?

The next few days could be pivotal to any concerns around the independence of the US Federal Reserve (Fed).

Fed Governor Lisa Cook was removed by President Trump for cause in late August, the first time in history such an event has occurred. She is now seeking a temporary restraining order that would prevent her removal for a few weeks, allowing her to temporarily remain a member of the Fed’s Board of Governors. A decision from the judiciary could reportedly be known today or tomorrow. At the same time, some Fed officials have been vocal about the need for the Fed to cut rates in the face of a deteriorating labour market; Christopher Waller and President Trump’s nominee Stephen Miran have stepped up the rhetoric in the last few days.

The US Treasury (UST) curve is projecting six rate cuts in the next 18 months or so, which would take the Fed Funds rate from 4.5% currently to a projected terminal rate of 3%. The Fed’s “dot plot” guidance, which will be updated at the September 16-17 meeting, shows a median long-term Fed Funds rate forecast of 3% (i.e. sometime from 2028 onward), though we note the dispersion around this prediction is large. The 10-year UST yield has been volatile recently, but at around 4.2% at time of writing it is within the recent range, albeit at the lower end of it. The two-year UST yield is around 3.6%, resulting in a 2s-10s slope of 60bp. This is below the long-term average but well within what most people would call a “normal” range.

Looking at these market levels and projections combined with recent developments in the labour market, our take is that the market’s pricing of future rate cuts is broadly consistent with the economic picture. Put another way, the market doesn’t seem to be expecting Fed officials to cut rates because their independence has been compromised, but because the slowing economy justifies cutting towards neutral. Even with the marked rise we have seen in 30-year UST yields, the 10s-30s slope is still only mildly above its average of the last 40 years.

While the threat to Fed independence has certainly become a topic of conversation among market participants and will have had some impact on UST yields and the slope of the curve, we believe a sharper steepening move is certainly possible if markets were to judge that the Fed’s independence had become compromised. Interestingly, if investors did have serious doubts about the Fed’s motivation for cutting rates, we would think the short end would be pricing in roughly the same number of cuts – the difference would likely be a sharp sell-off at the long end.

Labour markets are at the centre of monetary policy expectations, and Friday’s non-farm payroll data will of course be crucial, not just for the path of short-term rates but also for shaping perceptions of political bias in Fed officials’ decision making. If for example job creation were to outperform expectations and pick up, but certain Fed officials played it down and continued to argue for several rate cuts, we could see the curve bear steepening, given the short end is already pricing in said rate cuts and longer tenures would react negatively to the perception of political influence at the Fed.

With the next few days bringing a preliminary decision on Lisa Cook’s case, important labour market data, the September rate decision and revised dot plots, volatility in USTs is likely to remain high. Given valuations are pricing in several rate cuts already, but from what we can see not much of a “Fed independence premium”, we are wary of holding long dated duration positions at this stage.