Why bond investors are worried about who will be the next Fed chair

Bond investors have been expressing their concerns to the White House over the president’s potential Federal Reserve chair pick, the Financial Times reported. It seems bond investors in particular are sounding the alarm about the importance of the Fed’s independence. 

The easiest way to understand why it’s so important for the Fed to be independent, is to look at a time, when it was not more than 40 years ago.

“History provides a warning here,” said David Krause, emeritus professor of finance at Marquette University. “Arthur Burns and William Miller succumb to pressures of Nixon, Ford, and Carter to keep interest rates low, which continued to allow inflation to run unchecked.”

Inflation reached more than 13% in 1979. Eventually a new Fed chair, Paul Volcker, had to clean up the mess by severely raising interest rates — and it was grisly.

“I lived through this,” Krause said. “We went through a double dip recession in the early 1980s because we just had to wring inflation expectations out of the economy.”

It’s the inflation part of all of this that scares the bond market.

“Inflation is really the enemy of bonds,” said Collin Martin, head of fixed income research at the Schwab Center for Financial Research.

When you own a bond, you’re stuck with whatever interest rate it pays out. And if all of a sudden everything in your life is more expensive because of inflation?

“It makes that bond investment just less attractive in a high inflationary environment,” Martin said.

Investors don’t like losing money, so if they do start getting a whiff that inflation might ramp up again later, they’ll just refuse to buy long term bonds that don’t give them a little something extra to make up for it. 

So then, long-term bonds have to start offering that little something extra, and then all kinds of investments start doing the same, which makes borrowing in general more expensive.

“There is really no place you can hide in that environment,” said Fahd Malik, a portfolio manager at AllianceBernstein. “Treasury yields are rising, equities are most likely selling off, and credit is most likely selling off as well. That’s not good for capital markets.”

All that said, the name of the person who becomes the next Fed Chair isn’t as important as what they do.

“All of the candidates that are being floated do have credentials that would make them efficient leaders for the Federal Reserve,” said Marvin Loh, global macro strategist at State Street. “It really depends how they approach it.”

And whether history starts to rhyme.