Trump's efforts to remove Fed governor set to test Treasury market

By Davide Barbuscia

NEW YORK, Aug 26 (Reuters) - U.S. bond investors expect President Donald Trump's latest attempt to exert control over the Federal Reserve to push down the value of long-dated U.S. debt on concerns that an overly dovish U.S. central bank may lose its grip on inflation.

Late on Monday, Trump took his battle against the central bank to an unprecedented extreme with his effort to fire Governor Lisa Cook over questions raised over mortgages she took out before she joined the Fed. The bid to remove Cook comes as part of the relentless pressure Trump has put on the Fed to lower interest rates since he returned to the White House this year.

The move could kick off a protracted legal battle, but ousting Cook would give Trump’s Fed appointees a board majority that could sway future Fed leadership.

"Implications if this were to go through would be a relatively more dovish leaning board of governors and FOMC (Federal Open Market Committee), which potentially could mean looser-than-necessary monetary policy resulting in lower short-end yields but higher longer-term yields," said John Madziyire, head of U.S. Treasuries and Treasury Inflation-Protected Securities at Vanguard.

"This will result in higher term premiums on increased inflation expectations and higher uncertainty," he said, referring to the premium investors demand for the risk of owning long-dated U.S. debt securities rather than short-term ones.

The reaction to Trump's announcement on Cook was relatively muted on Tuesday due to uncertainty over whether his effort will be successful. Benchmark 10-year Treasury yields were roughly unchanged day on day at about 4.26%.

However, key parts of the Treasury yield curve steepened as short-term Treasury yields declined on stronger expectations of an imminent easing in monetary policy, and longer-dated yields rose on concerns that aggressive interest rate cuts could lead to higher long-term inflation. Yields rise when prices fall.

The closely watched yield curve comparing two- and 10-year Treasury yields steepened to its highest since April intraday on Tuesday, while the premium of 30-year yields over two-year yields surged to its highest since early 2022.

"We see further scope for Trump’s challenge to the Fed’s independence to push (the) term premium high and steepen the yield curve," BMO Capital Markets analysts said in a note on Tuesday.

While inflation has been trending lower in recent years after hitting a 40-year high in 2022, it remains above the Fed's 2% target, reducing the Fed's ability to cut rates aggressively despite a weakening in the labor market. Any excessive rate cuts could trigger a bond market response, as investors would lose confidence in the central bank's inflation-control focus.

"The bond market will likely punish cutting at the wrong time," said Tim Urbanowicz, chief investment strategist at Innovator Capital Management.

Concerns over a loss of Fed independence could be exacerbated by surging U.S. government debt levels, at a time when investors are already weighing the risk of "fiscal dominance," a scenario where keeping government financing cheap eclipses the fight against inflation.

"If public debt is high, there’s some temptation by government to use its influence on (the) central bank to revive growth and get a bit more inflation to erode the real value of its debt," said Gilles Moec, chief economist at AXA.

"Down the road this is going to become counterproductive because it will result in higher long-term rates,” he said.