Market Extra: Here’s how bond traders are preparing for Trump’s Fed chief pick

President Donald Trump’s search for a new Federal Reserve chief is turning into a drawn-out affair.

See: Is the Fed chair race more wide open than portrayed? Here’s what Mnuchin says

For bond traders, it comes down to whether Trump will nominate someone who will drive the central bank road a more hawkish road or keep it on the dovish path maintained under Federal Reserve Chairwoman Janet Yellen, whose term ends in February.

Treasury yields have ebbed and flowed as the hunt has thrown up a number of candidates including former Fed. Gov. Kevin Warsh, Fed. Gov. Jerome Powell, and Stanford economist John Taylor. And then there’s the possibility Trump could opt to reappoint Yellen.

Read: Trump’s pick to lead the Federal Reserve is (probably) on this list

“This process has conjured images of a White House version of ‘The Apprentice’ with pre-eminent economists in the roles of aspiring Trump assistants,” wrote Ian Lyngen and Aaron Kohli, fixed-income strategists at BMO Capital Markets.

Based on each candidate, market analysts have recommended traders place different types of wagers. But they all boil down to a bet on how short-dated yields move. Short-term Treasury notes, which are sensitive to changing expectations for central bank policy, would presumably be vulnerable to selling if a hawkish chair was selected, and buying if a dovish chair was chosen. Yields and bond prices move in opposite directions.

The dovish camp – Janet Yellen and Jerome Powell

Some have argued Trump would choose either the dovish Yellen or Powell, whose views closely align with those of Yellen. By choosing continuity, the White House would reveal its preference for lower interest rates to keep the economy chugging along.

“Yellen is by far the most dovish of all the candidates. Trump wants the economy running hot,” said Jim Leaviss, a money manager at M&G Investments. To be sure, some investors have changed their assessment on her policy views as she has spoken in support of further rate hikes even as the Fed struggles to reach its 2% inflation target.

Since early September, Treasury yields have climbed partly due to anticipation that Trump would choose a more hawkish Fed chair, with the 2-year Treasury yield

TMUBMUSD02Y, +0.28%

  setting a 10-year high. Part of that thinking was Yellen would not continue in her role next year because of her pro-regulation credentials. But if Trump does end up deciding on Yellen or Powell, it could unwind the recent bearish momentum and bring backpedaling traders into buying mode, pulling yields back down.

“With a larger list and a lengthening timeline, there’s also the risk that the nominee could ultimately be someone more “mainstream” (or even dovish). In this case, some of the hike pricing that has been rebuilt since September could reverse,” wrote Credit Suisse strategists led by Praveen Korapaty.

With that in mind, they proposed investors simultaneously buy a 5-year Treasury note

TMUBMUSD05Y, +0.86%

  and short the 30-year Treasury bond

TMUBMUSD30Y, -0.61%

A so-called “bull steepener,” the trade wagers the slope of the yield curve to turn steeper, that is, for short-term yields to fall more than long-term rates,

The yield curve is a line plotting the yields across Treasury maturities from the shortest dated to the longest. Traders tend to bet on the flexing of the curve by betting on the direction of both the short and the long-end as it amplifies the returns compared with a more simplified gamble on one part of the curve.

Of course, the bet could go painfully awry.

The hawkish camp—Kevin Warsh and John Taylor

For those who see a Republican White House in favor of less financial regulation, Fed. Gov. Kevin Warsh, a monetary policy hawk and a Republican, would seem to lead the race for the next Fed chair. Economists polled by The Wall Street Journal rated Warsh as the top candidate to take over from Yellen.

For those betting on Warsh’s candidacy, they could place a “bear flattener,” which would profit from short-term yields rising faster than long-term rates. This involves buying long-dated paper while selling the short-end.

“Markets would continue to push up U.S. rates on a Warsh announcement in a bearish flattening manner,” noted George Goncalves, head of U.S. rates strategy at Nomura.

News reports have indicated Taylor, creator of the eponymous Taylor rule, which would imply a desire for rates much higher than they are now, is among front-runners for the post.

See: What investors need to know about John Taylor and the Fed candidate’s famous rule

Taylor is seen as a bigger hawk than Warsh. Tom di Galoma, managing director of Treasurys trading at Seaport Global Securities, said Warsh has been more critical of the use of quantitative easing than low interest rates.

Taylor has also been critical of quantitative easing, while the Taylor Rule implies a desire for tighter monetary policy. A Taylor appointment could spark a sharp jump in short-dated yields, diGaloma said.