Citi Analysts Forecast Cautious Fed Balance Sheet Strategy Under Warsh
According to strategists at Citigroup Inc., Federal Reserve Chair nominee Kevin Warsh is expected to pursue a measured and gradual strategy for reducing the central bank's massive $6.6 trillion portfolio. This cautious approach aims to prevent reigniting the significant tensions that previously emerged in money markets.
Risks of Quantitative Tightening in Repo Markets
The strategists warn that any move by the Fed to resume its balance sheet unwinding process, known as quantitative tightening (QT), could potentially revive pressures within the enormous $12.6 trillion repurchase market. The Federal Reserve previously abandoned this QT process in December following dramatic surges in repo market rates, where financial institutions borrow and lend funds to meet daily operational requirements.
"The bar for restarting QT is quite high given the large volatility that repo markets experienced last year," wrote Citigroup strategists Alejandra Vazquez Plata and Jason Williams in their analysis. "Presumably, the FOMC would prefer to avoid a repeat of October 2025 and instead opt to take a gradual approach to balance sheet management."
Warsh's Historical Position and Fed's Portfolio Evolution
Kevin Warsh, a former Federal Reserve governor, has previously advocated for substantially reducing the central bank's financial footprint. This footprint expanded dramatically through successive rounds of asset purchases during both the global financial crisis and the COVID-19 pandemic. At its highest point in June 2022, the Fed's balance sheet had ballooned to approximately $8.9 trillion, representing a massive increase from just $800 billion nearly two decades earlier.
The Federal Reserve halted its portfolio reduction efforts following increased government borrowing late last year. This borrowing, combined with the ongoing unwind, created a notable squeeze by draining cash from money markets. In response, the Fed shifted to purchasing Treasury bills each month to replenish reserves within the financial system.
Potential Strategies for Portfolio Management
Despite these challenges, the Citigroup strategists identify several options available to a Warsh-led Federal Reserve for reducing its financial footprint. One approach involves shrinking the weighted average maturity of the Fed's holdings by rolling longer-maturity Treasury holdings into shorter-dated debt, which they describe as the "path of least resistance."
The presumptive chair could potentially build consensus among policymakers while simultaneously prioritizing committee support for interest-rate cuts. The strategists note that the Fed could also choose to decrease the pace of its Treasury bill purchases from the current level of approximately $40 billion per month, or potentially halt these purchases entirely. Additional options include allowing holdings of mortgage-backed securities to gradually roll off the balance sheet.
Projected Timeline and Market Implications
Citigroup's analysis indicates that even if the Federal Reserve were to terminate its purchases as early as June, reserves are unlikely to decline significantly by December 2026. The strategists anticipate policymakers will reduce the purchase pace to about $20 billion monthly starting in mid-April and continuing through the remainder of the year.
The New York Federal Reserve's open markets desk has projected that reserve management purchases will remain elevated for several months to counterbalance expected increases in non-reserve liabilities during April's tax season. Following this period, the overall pace of purchases is likely to be substantially reduced.
Minutes from the December Federal Open Market Committee meeting revealed participants' preference for purchases to focus on Treasury bills, allowing the composition of the Fed's portfolio to gradually shift toward matching outstanding Treasury securities. The Citigroup strategists suggest the Treasury Department would likely welcome this additional demand for T-bills from the Fed, potentially leaning more heavily on issuing short-dated debt while delaying increases in longer-term coupon offerings.
"As a result we expect coupon increases to begin in November 2026 with a risk to February 2027," the strategists concluded in their analysis.
