Federal Reserve Governor Dismissal Steepens U.S. Treasury Yield Curve by 116 Basis Points

The dismissal of a Federal Reserve governor by the United States President has raised concerns about the central bank's ability to manage inflation effectively, resulting in a steepening of the U.S. Treasury yield curve. The gap between 5-year and 30-year Treasury yields expanded to 116 basis points, marking the highest level since 2021. As of the latest reports, the 30-year Treasury yield increased to 4.932%, the 20-year yield to 4.898%, while the 2-year yield decreased to 3.717%.

The steepening of the yield curve is driven by market speculation that the President may appoint a policymaker more inclined towards easing monetary policy to replace the dismissed governor. This move aligns with the President's stance on urging the Federal Reserve to take action to ease monetary policy, which could help lower short-term interest rates but also risks elevating long-term inflation expectations.

A senior interest rate strategist noted that the dismissal highlights the unpredictable nature of the U.S. government, raising concerns that the Federal Reserve Board could be filled with dovish members. This could push up term premiums and long-term breakeven inflation rates, making the steepening of the yield curve understandable in the current environment.

The President, in a letter posted on a social media platform, stated that the dismissal was due to allegations of mortgage fraud against the governor. The President also asserted the constitutional authority to remove the governor from the Federal Reserve. The governor, however, responded by stating that the President lacks the authority to dismiss her and that she would not resign. The governor emphasized her commitment to stabilizing the U.S. economy and her legal team indicated that they would take all necessary legal actions to resist the dismissal.

The latest development has further dampened market sentiment towards U.S. assets, as traders have been seeking alternatives to the dollar and U.S. Treasuries throughout the year. Any perception of weakened Federal Reserve independence could accelerate this process. Market participants will closely monitor the response to this week's Treasury auctions, including those for 5-year and 7-year notes.

The dismissal could have profound economic and political implications. Removing the governor from the Federal Reserve Board would provide the President with an opportunity to appoint loyalists. The President has previously stated a preference for appointing officials who support rate cuts.

The Federal Reserve Board is the central decision-making body of the Federal Reserve, consisting of seven members appointed by the President and confirmed by the Senate. Besides the Chair, the remaining six members include the Vice Chair for Supervision and another governor appointed by the President during his first term. The rest of the members were appointed by the previous President. One member recently resigned, and the President has nominated the Chair of the White House Council of Economic Advisers to fill the vacancy.

A recent affirmation of the U.S. AA+ credit rating by a global rating agency came with a warning that political developments could put pressure on the rating if they undermine the robustness of U.S. institutions, the effectiveness of long-term policy-making, or the independence of the Federal Reserve.

A strategist from the National Australia Bank expressed concern that the dismissal could exacerbate worries about the erosion of Federal Reserve independence, assuming the governor has no legal recourse. If the President succeeds, it could mean that four out of the seven Federal Reserve governors would align with the President's stance. It remains to be seen whether these governors would respect the Federal Reserve's independence and adhere to its dual mandate.

The dollar index initially fell after the President's announcement but recovered some of its losses after the governor stated she would not resign. The President's attempt to exert greater control over the Federal Reserve is seen as a negative development for the dollar, which has already faced significant selling pressure this year. A strategist from the Commonwealth Bank of Australia noted that the dismissal could open the door for the President to appoint a new governor more likely to support rate cuts, further challenging the independence of the Federal Open Market Committee. This independence is crucial for the dollar's status as a safe-haven currency and could lead to further dollar selling.