Warsh Hints at QT, Bessent Denies. How Will Fed Rate Cuts and QT Policy Proceed? What Is the Impact on $30 Trillion in US Debt?

TradingKey - Following Kevin Warsh's nomination for the next Fed Chair, speculation about his "balance sheet reduction" process has already begun to brew. In response to market concerns, U.S. Treasury Secretary Scott Bessent stated on Sunday that he does not believe the Fed will move quickly to shrink its balance sheet.

However, it must be acknowledged that with Warsh's nomination, the creative ideas he previously proposed for managing the Fed will be brought to the table. One of the most central issues is the creation of a new version of the "1951 Accord" to restructure the relationship between the Fed and the Treasury. Analysts believe this move could affect the $30 trillion Treasury market and change the Fed's balance sheet management.

Warsh: Opposed to Unrestricted Asset Purchases and Prolonged Quantitative Easing

The "1951 Accord" mentioned by Warsh historically placed strict limits on the Fed's intervention in the bond market. At the end of WWII, the Fed suppressed interest rates to extremely low levels to support government financing and reduce borrowing costs during and after the war, which resulted in a massive surge in inflation. Consequently, in 1951, the Truman administration signed this agreement, formally granting the Fed the power to make independent monetary policy decisions, after which the Fed was no longer obligated to intervene indefinitely in Treasuries to suppress rates.

However, the current reality is that the Fed still plays a major role in the Treasury market because it conducted trillions of dollars in bond purchases during extreme periods such as the 2008 financial crisis and the 2020 pandemic. Regarding this, Warsh noted last April that the Fed's massive asset purchases post-crisis and post-pandemic violated the spirit of the 1951 Accord and fueled unrestrained government borrowing. Currently, the Fed's balance sheet stands at $6.6 trillion, primarily consisting of U.S. Treasuries and mortgage-backed securities.

Bessent holds similar views, criticizing the Fed for maintaining quantitative easing for too long and arguing that the Fed should only implement QE during "true emergencies" and in "coordination with other branches of government."

Warsh has stated that a new accord could define the size of the Fed's balance sheet, with the Treasury determining its debt issuance plan.

How Would Warsh’s Envisioned "New Accord" Affect U.S. Treasuries?

Bloomberg reported that this accord is highly controversial in the market: if it is only a minor bureaucratic adjustment, its short-term impact on the $30 trillion Treasury market will be minimal; however, if it truly involves the Fed's current portfolio of over $6 trillion in securities, it could not only heighten market volatility but also deepen concerns regarding the independence of the U.S. central bank.

Krishna Guha of Evercore ISI noted that this approach allows the Treasury to intervene in the Fed's decision-making, which investors might interpret as Bessent having a soft veto over any quantitative tightening (QT) plans.

Tim Duy, chief U.S. economist at SGH Macro Advisors, is more pessimistic, arguing that this accord is less about protecting the Fed and more like a Yield Curve Control (YCC) framework. This accord synchronizes the Fed's balance sheet with Treasury financing, explicitly linking monetary operations to the deficit.

In short, if this accord is ultimately signed, the Fed's function would undergo a fundamental change: if the balance sheet must match the scale and maturity of the Treasury's debt issuance, it would be virtually impossible for the Fed to independently determine the pace of expanding or shrinking its balance sheet.

Furthermore, the market expects the accord could shift the Fed's asset holdings from medium- and long-term securities toward Treasury bills (T-bills) with maturities of 12 months or less, which would help the Treasury reduce the issuance of medium- and long-term bonds.

Deutsche Bank predicts that a Fed led by Warsh could become an active buyer of Treasury bills over the next five to seven years; in one scenario, the proportion of Treasury bills in the Fed's holdings is projected to rise from less than 5% currently to 55%.

However, Ed Al-Hussainy, a manager at Columbia Threadneedle Investments, warned that serious problems would arise if the accord implies that the Treasury can rely on the Fed to absorb a portion of the debt over the long term.

Analysts have pointed out potential risks: if investors believe the Fed's bond-buying actions are entirely fiscally driven, will it still fully commit to fighting inflation? If investors perceive that the Fed has strayed from its core mission of combating inflation, it could trigger increased market volatility and rising inflation expectations, and in extreme cases, even undermine the status of the U.S. dollar and Treasuries as safe-haven assets.

Can Warsh’s Balance Sheet Reduction Plan Be Achieved?

George Goncalves, head of U.S. macro strategy at MUFG, believes that even if Warsh leads the Fed, he would not rapidly shrink the balance sheet because many changes in banking regulation would be required beforehand.

The current regulatory framework dictates how much in reserves banks must hold and the composition of those assets. One way banks obtain reserves is through the Fed purchasing securities from them and "crediting" the bank's reserve account at the Fed. In short, if the Fed stops purchasing securities from them, their reserves would decrease significantly, potentially falling below regulatory thresholds.