Donald Trump's nomination of Kevin Warsh for the next Federal Reserve Chair has sparked market concerns about balance sheet contraction. Although Warsh is known for his hawkish stance on the balance sheet, Citi believes a full restart of Quantitative Tightening (QT) is unlikely.
Citi analysts suggest that what truly deserves attention is an adjustment to the Weighted Average Maturity (WAM) of the Fed's SOMA investment portfolio—by rolling over maturing securities into short-term Treasury bills, the Fed could achieve balance sheet "slimming" without triggering market turmoil. This strategy could potentially free up approximately $420 billion in reinvestment capacity from the second half of 2026 through 2027. For investors, this implies further curve steepening, with the 3 to 5-year segment potentially becoming the best "safe haven."
Warsh's hawkish stance indicates a possibility of significant action on the balance sheet.
As a former Federal Reserve Governor, Kevin Warsh has consistently maintained a firm position on balance sheet issues. In a November article for The Wall Street Journal, he described the Fed's balance sheet as "bloated" and argued that it "could be reduced substantially. These generous resources could be redeployed in the form of lower interest rates." The market's immediate reaction aligned with Citi's expectations—a bull steepening (front-end yields falling, long-end under pressure), with the 30-year swap spread moving further negative. Simultaneously, the market began pricing in slight rate hike expectations for 2027/2028, although Citi believes Warsh's historical focus on inflation risks is less relevant in the current environment.
SOMA adjustment represents a more plausible path than a full QT restart.
Citi judges that a full QT restart would face significant resistance following last year's repo market volatility. A more probable course of action involves:
A reduction in Reserve Management Purchases (RMPs): decreasing from the current $40 billion per month to around $10 billion (Citi expects a natural decline to $20 billion after mid-April). However, this has limited macro impact. An adjustment to the WAM of the SOMA portfolio: shifting the proceeds from maturing Treasury coupon securities into short-term T-bills. At a monthly cap of $30 billion, this could achieve roughly $140 billion by the second half of 2026 and approximately $275 billion in 2027. This approach would likely garner broad support within the Fed.
Citi noted in its report that the Fed might increase the proportion of T-bills in its SOMA holdings from current levels to 40%. This adjustment is technically easier to execute and would not shock reserve levels as severely as a full QT restart. However, analysts acknowledge that while a full QT restart is not the base case, the possibility cannot be entirely ruled out. This would require the Fed to first refine the clearing mechanism for the Standing Repo Facility (SRF) to dynamically supplement reserves. Such a move would significantly reduce the WAM of SOMA and increase the Treasury's financing needs.
Concerns about term premium may be exaggerated.
From the Treasury's perspective, Citi argues that the rollover of any SOMA securities increases its financing needs—either requiring more T-bill issuance or larger coupon sizes. But if the Treasury continues to favor T-bill issuance, the yield curve may not steepen dramatically. Analysts warn that the real risk lies in another "buyer's strike" for U.S. Treasuries, potentially triggered by market panic (perhaps unfounded) over QT and/or expectations of larger future coupon auction sizes. There are current market fears that foreign demand could plummet, pushing up the term premium. However, Citi's data shows that foreign bidding in last year's 10-year note auctions actually strengthened. Typically, foreign demand in new issue auctions depends on the performance of prior reopenings. Recently, foreign participation in reopening auctions has been unusually high compared to new issues—this anomalous pattern suggests foreign demand in the next auction (tentatively February 11th) could remain robust.
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