A study by economist Thomas Drechsel examines how political influence affects Federal Reserve policy. The research uses diary records to track presidential interactions with the Fed. It highlights instances, such as during Nixon and Johnson’s presidencies, when the central bank responded to political pressure. This information is organized into a “political pressure” index. T.S. Lombard mentions that this study is relevant today. He points out that when the Fed eases policies due to political stress, it often results in higher inflation without improving real GDP. In fact, it can even lead to lower economic output. Additionally, as media attention on this pressure increases, inflation expectations often rise sharply.

Risks of Changing Fed Leadership

The study warns against changing the leadership of the Fed, like replacing the chair with someone more loyal to the president. This could damage trust in the Fed’s independence. Such actions might not be beneficial for risk assets and could destabilize the U.S. dollar. In this context, the euro, backed by a more independent European Central Bank, could gain an advantage. Given the risks of political interference in central bank policy, we advise traders to consider buying protection against market volatility. The VIX, which measures stock market volatility, has recently been around 13, significantly lower than its long-term average of about 20. This means options are currently fairly inexpensive, providing a good opportunity to hedge against potential declines in risk assets. Drechsel’s research shows that past political demands led to ongoing inflation, and we must be ready for similar situations. The current Consumer Price Index shows year-over-year inflation at 3.3%, well above the 2% target. We find value in contracts that benefit from rising prices, such as options on Treasury bond futures, which would increase in value if yields rise due to higher inflation expectations.

Impact of Fed Leadership Changes on the Market

If the Fed’s leadership changes, it could shake market confidence and cause a sell-off in stocks. To prepare for this, we’re buying put options on major indices like the S&P 500, directly hedging against a decline in economic output, as the study suggests is possible. Such a situation could also weaken the dollar’s appeal to global investors. We foresee a shift toward currencies supported by more independent central banks. Thus, we are considering long EUR/USD futures or call options to take advantage of potential changes in capital flows away from the U.S. Create your live VT Markets account and start trading now.

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