“For about an hour we had a brief glimpse of the likely market reaction as investors started to view Powell’s removal as a serious prospect,” Jim Reid’s team at Deutsche Bank told clients this morning.

The chaos fed through into the bond markets: “Notably, there was a huge steepening in the yield curve as investors ramped up the prospect of a near-term rate cut. Indeed at one point, a rate cut by September was priced as an 80% chance, having been at 57% the previous day. And at the lows, the 2yr yield was down -8.2bps on the day at 3.86%, whilst the 30yr yield surged by over 10bps in under an hour to an intraday peak of 5.07%.”

Outside the White House—and certainly on Wall Street—there is widespread agreement that replacing Powell with a Trump loyalist would be a bad idea. Especially for U.S. bonds.

“A fiscally compromised Fed (if not a fiscally ‘captured’ Fed) augurs poorly for the short-term real returns on long-term nominal assets, insofar as long-term inflation expectations may rise, and stay elevated and ‘sticky’,” Macquarie’s Thierry Wizman and Gareth Berry told clients in a recent note. “And under that backdrop of fiscal capture, the UST’s yield curve is now more prone to steepening than it is to flattening.”

The incident raised the issue of whether the president actually has the right to fire Powell. The law, as it stands, says he does not. But Trump has started building a case that Powell’s supervision of renovations at the Fed HQ building is somehow corrupt, in the hopes of being able to fire him “for cause.”

There would be resistance inside the Fed

So how likely is that Trump could replace Powell early, and how bad would it be if that replacement was not regarded as credible by the markets?

Goldman Sachs answered that question this morning in a note to clients that drew their attention to a paper they published back in May featuring an interview with former Fed Vice Chair Richard Clarida.

If the Supreme Court changed the law and made it easier for Trump to get rid of Fed chairs, it “would undoubtedly introduce huge uncertainty into financial markets and probably lead to expectations of higher inflation, as asset prices and capital flows are intimately related to investors’ assumptions that advanced economy central banks are reasonably independent, and that price stability is a reasonable long-term forecast,” Clarida said.

A noncredible chair would then face resistance from inside the Fed, Clarida says. “If a new chair were to attempt to pursue a policy demonstrably inconsistent with the Fed’s dual mandate, he or she could be outvoted. Now, by tradition and in practice, Fed chairs are very influential; I am hard-pressed to think of an instance when a Fed chair was outvoted on an [Federal Open Markets Committee] decision, and historical examples exist of FOMC members being seduced by bad policy, as occurred in the 1970s. But the committee structure of the Fed’s decision-making body acts as an important check on the power of any one individual in setting policy.”

At UBS, Paul Donovan agrees: “An obvious political stooge would probably be ignored by markets and the Fed itself. A modern-day equivalent of Fed Chair Burns [appointed by President Nixon] would be more troubling—superficially independent, but acting as the president’s spokesperson within the Fed.”

The importance of yesterday’s market volatility is that it shows we are in a new world where there is a genuine question over whether the Fed will operate with independence once Powell leaves in May. As Clarida told Goldman: “When I was Vice Chair, I thought the odds of the Supreme Court overturning the relevant court case that would make Fed independence null and void was essentially zero, and I can’t say the same today.”

Here’s a snapshot of the action this morning prior to the opening bell in New York:

• S&P 500 futures were flat this morning, premarket. The index closed up 0.32% yesterday. 
• STOXX Europe 600 was up 0.7% in early trading. 
• China’s CSI 300 Index was up 0.68% this morning. 
• Japan’s Nikkei 225 was up 0.6%. 
• The UK’s FTSE 100 was up 0.4% in early trading. 
• Bitcoin was holding on at the $118K level.