Market Reaction to Potential Fed Chair Change

As investors adjust their expectations, a shift in Federal Reserve leadership could significantly influence Treasury yields and the broader economic landscape. With incoming Chair Kevin Warsh advocating for interest rate reductions alongside a smaller central bank balance sheet, market dynamics are poised for noteworthy changes.

NEW YORK, Feb 3 (Reuters) – Investors are increasing their bets on both rising long-term Treasury yields and a steeper yield curve. This comes in anticipation that incoming Federal Reserve Chair Kevin Warsh will push for interest rate cuts while simultaneously reducing the U.S. central bank’s balance sheet.

Warsh’s inclination toward a considerably smaller Fed balance sheet, currently valued at approximately $6.59 trillion, suggests a withdrawal of significant government demand for Treasuries. This contraction may tighten financial conditions, as the central bank will not be injecting liquidity into the market.

The reduction in Fed bond reinvestments and purchases will likely lead to an increase in Treasury supply, and consequently, elevate long-dated yields, thereby steepening the yield curve.

Eric Kuby, Chief Investment Officer at North Star Investment Management Corp in Chicago, commented, “The primary consequence of shrinking the balance sheet would result in a yield curve that more naturally slopes positively, resembling historical patterns prior to extensive intervention following the financial crisis.”

The yield curve—the difference between short-term and long-term interest rates—is a crucial indicator of economic expectations. It’s known to steepen when investors grow increasingly wary about inflation and rising fiscal deficits. Higher long-term yields can greatly affect borrowing costs across various sectors, making mortgages, corporate bonds, leveraged loans, and equity financing all more expensive.

On the other hand, short-term yields are expected to remain low under Warsh’s leadership, accentuating the steepness of the curve. Despite his past reputation as a hawk during his tenure as a Fed governor from 2006 to 2011, Warsh has recently adopted a more dovish stance, aligning with President Donald Trump’s expectations for near-term rate cuts.

Prior to Trump’s nomination of Warsh to succeed Fed Chair Jerome Powell this spring, the Treasury curve was already steepening, with long-term rates surpassing short-term rates. This steepening trend was largely driven by inflation concerns and apprehensions that escalating fiscal deficits would necessitate increased debt issuance, consequently raising yields.

On Tuesday, the Treasury 2/10-year yield curve saw a slight flattening, hitting 72.70 basis points a day earlier, marking its steepest point since April 9—just after Trump announced tariffs on various products from U.S. trading partners.

Currently a visiting fellow at Stanford University’s Hoover Institution, Warsh has indicated that productivity gains driven by artificial intelligence have a disinflationary effect, thereby allowing the Fed to relax its monetary policy.

U.S. rate futures suggest that traders anticipate approximately two quarter-percentage-point rate cuts this year, with the initial reduction expected during the June 16-17 meeting. This reflects confidence that a Warsh-led Fed will focus on normalizing borrowing costs.

While Powell’s term as Fed chair concludes in mid-May, Warsh still requires confirmation from the U.S. Senate.

However, analysts point out the inherent tension between reducing the Fed’s balance sheet and achieving the lower long-term rates desired by the Trump administration. If the balance sheet contracts while long-term rates remain high, term premia—the additional yield investors demand for taking on duration risk—may remain elevated or potentially increase, complicating efforts to ease financial conditions via traditional rate cuts.

Jim Barnes, Director of Fixed Income at Bryn Mawr Trust in Berwyn, Pennsylvania, noted, “It’s challenging to execute such a policy. On one hand, you’re using a dovish approach, like lowering rates; on the other, you’re enacting policies that result in higher rates, such as reducing the balance sheet. These objectives are contradictory. The question becomes: how do you implement them simultaneously?”

Technical Challenges and Interest Rate Volatility

Lou Crandall, Chief Economist at Wrightson-ICAP, pointed out that any strategy to reduce the Fed’s assets will involve intricate technical challenges—particularly concerning bank liquidity regulations—and will require time to unfold.

Market participants also foresee increased interest rate volatility, as some consider Warsh to be a contentious figure given his earlier criticism of the Fed. Oscar Munoz, Chief U.S. Macro Strategist at TD Securities in New York, remarked that this scenario might alienate certain members of the central bank’s policy-setting committee.

“We observe that the former governor is difficult to categorize due to his significant shift in policy priorities after advocating for a hawkish stance during the Global Financial Crisis (GFC),” Munoz added.

Bond market participants, however, expect Warsh to eventually revert to his hawkish tendencies, which could further heighten interest rate volatility.

Felix-Antoine Vezina-Poirier, Associate Strategist at BCA in Montreal, stated that while Warsh has cited AI-driven productivity gains as a reason not to worry about future inflation, increased productivity suggests a higher neutral federal funds rate.

The MOVE index—a measure of interest rate volatility—has been on the decline in recent months and has yet to account for Warsh’s impending role as Fed chair. The index was last recorded at 59.30, down from 84.32 in mid-November.

“Only time will reveal how Warsh performs as chairman. He has historically been an inflation hawk,” said Benjamin Connard, Portfolio Manager at Carnegie Investment Counsel in Stamford, Connecticut. “His recent changes may simply be a strategy to secure the nomination. Keep in mind, rates are set by the majority. Warsh alone doesn’t have the authority to lower them. For long-term investors, as long as confidence in the Fed remains steady, this nomination should not alter your outlook.”

Reporting by Gertrude Chavez-Dreyfuss; Additional contributions by Suzanne McGee and Laura Matthews; Editing by Megan Davies and Paul Simao