Warsh Will Face Challenges Shrinking Fed’s Portfolio, Citi Says
(Bloomberg) — Federal Reserve Chairman nominee Kevin Warsh is likely to take a gradual approach to shrinking the central bank’s $6.6 trillion portfolio to avoid reigniting money market tensions, according to strategists at Citigroup Inc.
Any attempt by the central bank to continue unwinding its balance sheet, a process known as quantitative tightening, could revive pressures on the $12.6 trillion buyback market, strategists said. The Fed abandoned the process in December after interest rates increased in the repo market, where banks borrow money from each other for daily needs.
“Given the massive volatility repo markets experienced last year, the bar for relaunching QT is pretty high,” strategists Alejandra Vazquez Plata and Jason Williams wrote. “Presumably the FOMC will prefer to avoid a repeat of October 2025 and instead take a gradual approach to balance sheet management.”
Former Fed Governor Warsh called for a dramatic reduction in the central bank’s fiscal footprint, which has ballooned due to repeated asset purchases amid the global financial crisis and the Covid-19 pandemic. At its peak in June 2022, the Fed’s balance sheet had grown to $8.9 trillion, up from just $800 billion nearly two decades earlier.
The Fed stopped shrinking its portfolio after a surge in government borrowing late last year; This caused a significant squeeze as cash was withdrawn from money markets along with the easing. He then turned to purchasing Treasury bills every month in order to restore reserves to the financial system.
The Warsh-led Fed still has options to reduce its footprint, according to Citi strategists. It can narrow the weighted average maturity of its assets by converting long-term Treasury assets into short-term liabilities as the “path of least resistance.” They said the would-be president could reach a consensus among policymakers while prioritizing getting the committee’s support for rate cuts.
The Fed may also choose to reduce the pace of its purchases of Treasury bills, which are about $40 billion a month, or stop them altogether, strategists said. Other options include divestitures of mortgage-backed securities.
An analysis from Citi shows that even if the Fed ended its purchases as early as June, reserves are unlikely to decline significantly until December 2026. They expect policymakers to slow the pace of purchases to about $20 billion per month starting in mid-April and continuing through the rest of the year.
The New York Fed’s open markets desk has forecast that reserve management purchases will remain high for several months to offset expected large increases in non-reserve liabilities during the April tax season. After that, the pace of total purchases will likely slow down significantly.
Minutes of the Federal Open Market Committee meeting in December showed that participants expressed a preference for purchases to be made in Treasury bills, thus beginning to shift the composition of the Fed’s portfolio toward outstanding Treasuries.
Citi strategists said the Treasury will likely be pleased with the Fed’s additional source of demand for Treasury bills and will shift more toward short-term debt issuance while suppressing increases in long-term coupon supplies.
“As a result, we expect coupon increases to begin in November 2026, with exposure to February 2027,” they wrote.
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