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Kevin Warsh’s long-held desire to slash the Federal Reserve’s balance sheet is likely to clash with Donald Trump’s relentless calls for the central bank to depress long-term borrowing costs, big fund managers have said.
Longer-dated Treasury yields rose on Friday as investors bet Trump’s nomination of Warsh to lead the world’s most influential central bank could push up borrowing costs. The move pushed the difference between 30-year and two-year debt yields — a measure that is closely watched on Wall Street — to 1.35 percentage points, close to the biggest gap since 2021.
The market fluctuations are an early sign of how traders are assessing Warsh’s statements in recent years, in which he has criticised the central bank for the scale of its bond purchases during the 2008 financial crisis — when he was a Fed governor — and later during the 2020 pandemic.
“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,” said Greg Peters, co-chief investment officer of PGIM fixed income.
Warsh served as Fed governor from 2006 to 2011 and has since become a prominent critic of some of the central bank’s flagship policies, particularly the multiple rounds of quantitative easing that left it holding almost $9tn of US Treasuries and other assets at its peak.
He has argued that the persistence of a vast balance sheet distorts asset prices and could risk entrenching inflationary pressure, even as he has argued that the US economy faces downside risks that justify a lower policy rate.
“The Fed has been the most important buyer of US Treasury debt — and other liabilities backed by the US government — since 2008,” Warsh said in a widely followed speech in April, adding that, “it’s a proxy for the Fed’s growing imprimatur on the economy”.
Stanley Druckenmiller, the billionaire investor and long-time mentor of Warsh, told the FT on Friday that the policymaker was not a permanent “hawk” and that “I’ve seen him go both ways” on monetary policy.
Some investors think he could push for lower short-term interest rates in the hope that advances in productivity caused by the AI boom would allow the economy to grow quickly without producing much inflation.
The Fed cut interest rates by 0.75 percentage points last year, but it signalled earlier this week that it would hold off on cuts for some time since growth has been strong and the jobs market appears to be stabilising after a period in which it was showing signs of weakness.
After Trump nominated Warsh, markets continued to price in two quarter-point rate cuts beginning this summer, indicating that traders’ short-term views on the Fed remain intact.
Bill Campbell, a portfolio manager at DoubleLine, noted that there would be tension if Warsh agitated for lower short-term rates while also pursuing a smaller balance sheet at a time of growing government debt and persistently high inflation.
“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,” he said, adding: “I believe Kevin Warsh fully understands this.”
The Fed ended its quantitative tightening programme to reduce its balance sheet late last year amid concerns over shrinking liquidity in short-term funding markets — easing some concerns over demand for sovereign debt issuance as analysts forecast an expansion in the central bank’s bond-buying.
“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,” said Mark Dowding, head of active fixed income at RBC BlueBay Asset Management.
