Markets warn Fed balance sheet cuts could clash with Trump’s rate goals

Major investment firms are warning that the next Federal Reserve chief’s plans to reduce the central bank’s holdings could work against the president’s push for cheaper borrowing.

Donald Trump’s pick to run the Federal Reserve is facing a possible conflict. On one side, there’s Warsh’s known preference for cutting the central bank’s massive bond portfolio. On the other, the president’s repeated demands for lower long-term interest rates.

Treasury markets moved on Friday following Kevin Warsh’s appointment. The difference between 30-year and two-year rates grew to 1.35 percentage points as investors drove higher yields on longer-term government paper. The fact that the spread is almost at its biggest point since 2021 demonstrates how Wall Street has responded to Warsh’s remarks in recent years.

Markets react to balance sheet concerns

The market response points to an early reading of Warsh’s past statements. He’s criticized the Fed for buying too many bonds during the 2008 financial crisis, when he worked as a Fed governor, and then again during the 2020 pandemic response.

Greg Peters works as co-chief investment officer at PGIM fixed income. He explained what’s got the market worried. “You have an anti-balance sheet expansion guy against a backdrop of wanting lower interest rates. It’s a tension point. That’s what the market is focused on. That’s why the curve is steepening out,” Peters said.

Warsh spent five years at the Fed from 2006 to 2011. Since leaving, he’s spoken out against some of the central bank’s major policy moves. The rounds of bond buying that left the Fed holding close to $9tn in Treasury bonds and other securities at the highest point? He takes particular issue with those.

His argument is that keeping such a large balance sheet warps the prices of investments and might lock in higher inflation over time. But at the same time, he’s said the economy faces risks that support cutting the Fed’s main interest rate.

Warsh addressed the Fed’s role in debt markets during an April speech that drew wide attention. “The Fed has been the most important buyer of US Treasury debt, and other liabilities backed by the US government, since 2008,” he said. He added that “it’s a proxy for the Fed’s growing imprimatur on the economy.”

Stanley Druckenmiller, a billionaire investor who’s advised Warsh for years, told the Financial Times on Friday that his protégé does not stick to one position. “I’ve seen him go both ways” on monetary policy, Druckenmiller said. Warsh is not permanently hawkish on rates, the investor suggested.

Some market watchers think Warsh might push to cut short-term rates. “ Their reasoning is based on expectations that artificial intelligence will boost productivity. Under this view, the economy could expand quickly without creating much inflation.

Challenges of balancing competing priorities

The Fed lowered rates by 0.75 percentage points last year. But earlier this week, officials signaled they plan to pause cuts for now. They pointed to solid economic growth and a job market that appears steadier after showing some weakness.

Markets still expect two quarter-point cuts starting this summer after Warsh’s nomination. This shows traders have not changed their near-term Fed outlook.

Bill Campbell manages portfolios at DoubleLine. He pointed out the challenge if Warsh wants both lower short-term rates and a smaller balance sheet while government debt grows and inflation stays elevated. “Until you get fiscal under control and inflation under control, you are not going to be able to aggressively reduce interest rates and shrink the [Fed’s] balance sheet,” Campbell said. He added that “I believe Kevin Warsh fully understands this.”

The Fed stopped its program to shrink its balance sheet late last year. Officials worried about drying up cash in overnight lending markets. This decision eased some concerns about who will buy all the government debt, especially as analysts predicted the central bank might start expanding its bond holdings again.

Mark Dowding runs active fixed income at RBC BlueBay Asset Management. He described the problem with using balance sheet cuts to justify rate reductions. “The issue is if you justify rate cuts by cutting the balance sheet, this does nothing to help lower long-term rates and improve mortgage affordability, which is what Trump wants,” Dowding said.

The competing priorities create uncertainty about how Warsh would balance the administration’s political goals with his stated policy preferences if confirmed to lead the central bank.

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