China International Capital Corporation (CICC) has released a research report stating that the nomination of Kevin Warsh by US President Trump on January 30th local time as the next Federal Reserve Chair has sparked market concerns over his past quantitative tightening (QT) rhetoric. However, given the strong constraints imposed by the current operational dynamics of the US dollar liquidity system and the overarching trend of expansive fiscal policy, the choice of Fed Chair is unlikely to significantly alter the trend towards normalized balance sheet expansion. The global bull market in assets has the potential to persist, and for the remainder of the year, CICC maintains a positive outlook on China-US equities—particularly the Chinese stock market, which remains significantly underweighted by global active funds—as well as gold, silver, and copper, all of which stand to benefit from the trend improvement in US dollar liquidity.
CICC points out that a series of liquidity stress events—including reciprocal tariffs last April, the government shutdown in October, and the recent sell-off in US Treasuries triggered by the Greenland dispute earlier this year—increasingly demonstrate that both the expanding US fiscal financing needs and the stable operation of the American financial system are highly dependent on the Federal Reserve's "ample liquidity" framework as the ultimate backstop. With midterm elections approaching, neither fiscal austerity nor a financial crisis is an outcome the Trump administration desires. Since last year, CICC has consistently highlighted the likelihood of the Fed halting QT and initiating balance sheet expansion, a view that was validated in April and again at year-end. Although the Fed commenced expansion in late December, leading to marginal liquidity improvements, narrow liquidity (bank reserves) remains well below the lower bound of "ample levels." Both quantitative and price indicators for US dollar liquidity suggest conditions are still relatively tight compared to the post-pandemic period, which CICC identifies as the root cause of the recent panic selling in markets.
Under the combined pressures of debt, electoral politics, and financial market stability, the specific individual chosen as Fed Chair may matter less than commonly assumed. A trend towards liquidity expansion remains a high-probability event. The fundamental reason why balance sheet expansion is difficult to halt stems from the monetary policy framework established by the Fed post-2008, which operates based on "ample reserves." Since the financial crisis, persistently abundant market liquidity and ultra-low interest rates have profoundly influenced financing behaviors within the financial industry—for instance, the banking sector's widespread reliance on demand deposit funding and the growing non-bank sector's (e.g., hedge funds) heavy dependence on the overnight repo market. Consequently, as the scale of financial activity expands, a larger volume of ultra-short-term liquidity (i.e., reserves) is required to sustain the system. When liquidity falls below a critical threshold (estimated by the Fed to be around 10%-11% of GDP), financial market risks become more likely. Indeed, financial stresses since 2019 have occurred as liquidity approached or fell below this threshold (Chart 1). This, of course, is the structural issue Warsh has identified with QE policies. However, resolving such a deeply embedded structural problem likely requires a major breakdown to force a major rebuild—the question is whether the Trump administration, the Fed, Main Street, and Wall Street possess the resolve and courage to endure such a "major breakdown," especially since maintaining financial stability is a core mandate of the Fed.
Historical experience suggests that the impact of a financial crisis on the real economy often lasts longer than its impact on financial markets themselves. For example, following the 2007 subprime mortgage crisis, the US economic recession persisted until 2009, with a tepid recovery thereafter, while financial markets had rebounded by 2009. The true force compelling the Fed towards常态化 expansion today is the binding of monetary policy by fiscal dominance. As mentioned, the US financial market is heavily reliant on repo financing, with US Treasuries serving as the core collateral in the repo market (Chart 3). This means that if there is insufficient demand for new Treasury issuance, a decline in Treasury prices would concurrently tighten market financing conditions, amplifying the contractionary effect through the "collateral multiplier." Therefore, the combination of fiscal expansion, an ample liquidity system, and QT is inherently contradictory. QT has typically ended by triggering risks in the Treasury-repo market (a potential systemic risk), forcing the Fed to intervene with renewed QE to stabilize markets. The repo market stress of September 2019, the Treasury market turmoil of March 2020, the reciprocal tariff issues last April, and the Fed's subsequent rapid pivot on QT policy have repeatedly demonstrated this outcome.
Since the beginning of 2024, CICC has consistently argued that, given current domestic wealth inequality and global geopolitical and technological competition, the likelihood of significant US fiscal austerity is low. This is particularly true in an election year where pressure for midterm elections makes Trump's impetus for fiscal expansion even more urgent. Given that Warsh was meticulously selected by Trump, CICC estimates it is highly probable he will largely adhere to the administration's policy priorities. Much as Governor Miran emphasized strict Fed independence before his appointment to the FOMC but subsequently advocated for significant rate cuts, CICC expects Warsh's perceived "hawkishness" may face practical constraints. Winning the midterm elections and achieving manufacturing reshoring during Trump's foreseeable term constitute the paramount "political correctness," likely necessitating continued monetary accommodation—through rate cuts and balance sheet expansion (and potentially even Yield Curve Control). Within this framework, Warsh might simultaneously advance deregulation of the US banking sector, such as fully removing Supplementary Leverage Ratio (SLR) restrictions on holdings of MBS and US Treasuries, to incentivize market absorption of debt and alleviate pressure on the Fed to resort to QE.
In the long run, shifting the US economy from a financialized to a more production-oriented base does not imply a crude suppression of the financial sector, especially considering the profound and lasting impact financial crises can have on the real economy. Similar to the persistent calls from figures like Beshon for the Fed to focus on vulnerable sectors like housing, CICC anticipates that "脱虚向实" (shifting from virtual to real economy) will more likely involve monetary policy structurally channeling liquidity, in coordination with fiscal policy, towards specific real-economy sectors to more effectively stimulate manufacturing reshoring and ease financing burdens on households and small businesses. Regarding asset allocation, CICC reiterates its expectation for a dual easing of fiscal and monetary policy this year. A restart of the US nominal economic cycle appears likely, accompanied by both quantitative and price-based easing in dollar liquidity, which should support global risk assets, including gold, silver, and copper. This environment is particularly favorable for emerging markets (such as the Chinese equity market, which remains significantly underweighted by global active funds) and commodities like gold, silver, and copper.
At the sector level, with potential backing from the Fed, the Trump administration may further accelerate the restructuring of the geopolitical landscape, elevating the importance of security and supply chain resilience. This continues to favor two main themes: productivity enhancement (technology and industry) and resource self-sufficiency. Of course, persistent balance sheet expansion could further stimulate speculative behavior among financial institutions, increasing market bubble risks, amplifying short-term volatility (e.g., in gold, silver, copper), and posing greater challenges for future monetary policy.
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