The Crude Oil Trader: Bullard

By Jared Dillian

I had an instant messenger conversation with one of my clients the other day. It was pretty annoying—he wrote things like “BULL MARKET, DUDE,” and harangued me about my net-short positioning. Then he started telling me that the market was going to rip if the Republicans took both houses of Congress in the midterm elections. At that point, I felt like I needed to intervene.

First of all, just about every single piece of academic research on the subject shows that the stock market (and GDP, and many other metrics) outperforms under Democratic presidents. You don’t need to look very far for a contemporary example, considering that the stock market has done a three bagger under our current leader, and the economy has recovered.

Wait, that doesn’t make any sense. The current administration is the least friendly to business and private enterprise in recent history—so why have stocks been in a prolonged bull market? There are a million reasons why, but let’s focus on the biggest and most obvious one: the Federal Reserve.

Shaping the Fed Board of Governors

Lots of people have opinions on the Fed without really knowing the Fed as an institution or how it works.
To review, there are seven members of the Federal Reserve’s Board of Governors who live and work in Washington, DC. They are presidential appointees, and their term of service is 14 years.

There are 12 regional bank presidents, who are nominated by their respective boards of directors. They are not, theoretically speaking, political appointees. Four of them at a time serve on the FOMC, on a rotational basis. The president of the New York Fed is a permanent member of the FOMC. Their term of service is five years.

In the old days, a Fed governor would serve all 14 years, but now they have to go make money on the speaker circuit, so they serve only three to five years if they are lucky. This means that a two-term president has the opportunity to “pack the court” with Fed governors of similar political affiliation over an eight-year period.

I would argue that the power to shape the Fed Board of Governors is even greater than the power to shape the Supreme Court.

Look at the current Board of Governors:

Janet Yellen
Stanley Fischer
Daniel Tarullo
Jerome Powell
Lael Brainard

There are two vacancies, but these are all Obama appointees. Yellen served as president of the San Francisco Fed before joining the Board of Governors as vice chair.

By and large, you can divide up central bankers into two camps: dovish central bankers, who prefer easy monetary policy (low interest rates) and hawkish central bankers, who prefer tighter monetary policy (high interest rates). Dovish central bankers tend to be Democrats. Hawks tend to be Republicans. It’s not a one-for-one correlation, but it’s close.

Everyone currently on the Board of Governors is a dove. (Powell is sometimes thought of as a centrist.) There are some hawks at the regional Federal Reserve banks, since the boards of directors are businesspeople and tend to appoint other businesspeople. Jeffrey Lacker, Charles Plosser, and Richard Fisher are all notable hawks. Inconveniently, though, they only end up on the FOMC once every three years.
George W. Bush packed the Fed, too (Duke, Warsh, Mishkin, Kroszner), but his appointees are all gone now. However, if they had served out their 14-year terms, they would still be around, and we would have a much more balanced Fed.

What Life Would Look Like Under a Hawkish Fed

Even though the presidential election is two years away, I think it’s worth having this conversation today. Seriously, what would happen if someone like Rand Paul became president? And Congress were solidly Republican?

Let’s start with the Fed. Yellen would not be reappointed; that is very clear. Over the course of a few years, the Board of Governors would be reshaped.

It’s hard to imagine in a day and age where every time a relatively benign stock market correction occurs, Fed officials are dropping hints of quantitative easing, but a hawkish Fed wouldn’t go for that kind of stuff. It would allow the market to purge its own excesses. It might even be a little laissez-faire.

We’ve had an interventionist Fed and an interventionist monetary policy on and off throughout the history of central banking, but especially since 1998, when the Greenspan Fed bailed out everyone during the blowup of Long-Term Capital Management (LTCM).

I remember reading articles about the “Greenspan Put” in 2000. That turned into the Bernanke Put, then the Yellen Put, and more recently, the Bullard Put. If there’s a perception that the Fed doesn’t allow the stock market to go down, it is probably because the Fed really doesn’t want the market to go down.

All kinds of conspiracy theories have blossomed from this (the Plunge Protection Team, for example), which I don’t like. But the Fed has nobody to blame but itself.

Under a hawkish Fed, valuations would be sharply lower. “Sharply” is italicized here for a reason. If we get away from QE and ZIRP and back to something resembling a normal rate environment, you’d be looking at the stock market being down 20-40%.

Would a Republican Midterm Win Be Bullish?

Aside from the Federal Reserve, a Republican administration, together with Congress, would completely reshape government, in ways that we can’t even conceive of right now. Would the resulting legislation be more business-friendly? Well, it might be more market-friendly, and market-friendly and business-friendly are two different things.

I think there is a reason that the stock market outperforms during Democratic administrations. Two, actually.

Republicans appoint hawkish Fed officials who tend to tank the market.
Republicans tend to pass supply-side legislation, which works with a long lag.

I think Reagan should get credit for the massive expansion of the ‘80s and ‘90s, and Clinton should get credit for expanding free trade, but people forget that the early years of Reagan’s presidency were very tough. Paul Volcker unleashed a hurricane-force bear market—the ‘82 recession was one of the worst on record, though the economy recovered quickly.

So, no—I don’t think it’s clear that Republicans winning the midterm elections is bullish at all, aside from what a few computer algorithms will do the day after. In fact, I think it could be the prelude to a lot of pain in the markets.

I’m sure investors will be exchanging some inadvisable fist bumps the morning after Election Day. When George W. Bush was reelected in 2004, the market went bananas, but let’s not forget that he campaigned on lower taxes on dividends and capital gains. 2016 will be very, very different.