Investors are increasing their bets on higher long-dated Treasury yields and a steeper yield curve, anticipating that incoming Federal Reserve Chair Kevin Warsh will push for interest rate cuts while simultaneously reducing the U.S. central bank’s balance sheet. A preference for a smaller Fed balance sheet, currently around $6.59 trillion, suggests a reduction in government demand for Treasuries, tightening financial conditions as the central bank curtails liquidity.
Reduced Fed bond reinvestments and purchases would expand the Treasury supply in the market, driving long-dated yields higher and steepening the curve. Eric Kuby, chief investment officer at North Star Investment Management Corp, said that shrinking the balance sheet would result in a more positively sloped yield curve, resembling historical patterns before intervention following the financial crisis. The yield curve, which reflects the gap between short- and long-term rates, steepens when investors worry about inflation and widening fiscal deficits.
Warsh’s dovish stance on near-term rate cuts, aligning with President Trump’s expectations, contrasts with his reputation as a hawk during his tenure as a Fed governor from 2006 to 2011. This shift has led market players to anticipate higher interest rate volatility. Oscar Munoz, chief U.S. macro strategist at TD Securities, noted that Warsh’s perceived inconsistency could alienate members of the central bank’s policy-setting committee.
Analysts point out the potential conflict between reducing the Fed’s balance sheet and achieving the lower long-term rates desired by the Trump administration. Jim Barnes, director of fixed income at Bryn Mawr Trust, said cutting rates while shrinking the balance sheet present conflicting policies, raising questions about implementation. Warsh, currently a visiting fellow at Stanford University’s Hoover Institution, must be confirmed by the U.S. Senate after Powell’s term ends in mid-May.
