Markets are cruising at all-time highs, but a major risk lurks below the surface: the end of Fed independence.
It's no secret that President Donald Trump and Federal Reserve Chair Jerome Powell do not see eye-to-eye. The president has repeatedly called for Powell to cut rates and threatened to fire him.
Last week, the feud escalated to another level when Russell Vought, a senior Trump administrator, criticized Powell for renovations of the Federal Reserve headquarters running over budget and said he should be investigated for mismanagement.
This shouldn't be dismissed as bluster from the administration, Deutsche Bank warned on Friday.
George Saravelos, the bank's global head of FX research, said investors are seriously overlooking the danger of Trump removing Powell. Markets are pricing in just a 20% chance of Powell's removal this year, and the dollar index is indicating that investors aren't detecting a threat to Fed independence.
If Trump were to remove Powell, the consequences would be severe, Saravelos said.
"In extreme cases, both the currency and the bond market can collapse as inflation expectations move higher, real yields drop and broader risk premia increase on the back of institutional erosion," Saravelos wrote.
The Trump-Powell feud poses severe risks to the currency and bond market. In the event of Powell's removal, Saravelos anticipates the dollar would immediately plunge 3%-4%. This would be followed by a 30-40 basis point sell-off in US Treasurys, especially among longer-dated bonds. Borrowing costs would rise overnight and inflation would creep up, leading to the exact opposite of what Trump intended by firing Powell.
Additionally, the growing budget deficit is already posing a threat to bond yields, meaning that the consequences of Powell's removal would be amplified.
"This raises the risk of far larger and more disruptive price moves than ones we have outlined here," Saravelos wrote.
As tariff deadlines are pushed back and stocks soar to new highs, perhaps investors believe the TACO trade will act as a backstop for markets again. But Saravelos doesn't think investors should brush off Trump's threats when it comes to Fed independence, as there is historic precedent for the central bank being influenced by political pressure.
In the 1970s, President Richard Nixon pressured Fed Chair Arthur Burns to keep rates low, worsening the country's stagflation crisis. Saravelos believes the implications would be more serious today, as the US has much higher debt levels, and capital markets are much more concentrated in the US.
Even if Trump doesn't go through with his threats of removing Powell, the ongoing feud still injects lasting uncertainty into markets.
"We would expect a sustained and persistent risk premium to be subsequently embedded in both the US dollar and the Treasury market, with exceptionally high sensitivity to both the mix of data and the conduct of monetary policy in the subsequent months," Saravelos wrote.
"In sum, we consider the removal of Chair Powell as one of the largest under-priced event risks over the coming months."
