During his campaign for the position of Federal Reserve Chair, Kevin Warsh proposed numerous ideas on how he would lead the Federal Reserve.
For Wall Street, few ideas were as obscure and potentially far-reaching as his call for a 'new accord' with the Treasury Department...
During his campaign for the position of Federal Reserve Chair, Kevin Warsh proposed numerous ideas on how he would lead the Federal Reserve. For Wall Street, few ideas were as obscure and potentially far-reaching as his call for a 'new accord' with the Treasury Department...
Warsh expressed support for overhauling the relationship between the two institutions through the establishment of a new version of the 1951 Fed-Treasury Accord.
The agreement from that year had greatly restricted the Fed’s footprint in the bond market—restrictions that have since disappeared amid trillions of dollars in securities purchases during the global financial crisis and the COVID-19 pandemic. Therefore, when President Trump nominated the 55-year-old Warsh to be the next Federal Reserve Chairman, investors began speculating about his true intentions.
Neither Warsh nor Treasury Secretary Scott Bessent provided detailed explanations of the potential plans the former Fed governor might consider upon taking office. However, Warsh stated in an interview last year that the new accord could “clearly and prudently define” the scale of the Fed’s balance sheet while allowing the Treasury Department to outline its debt issuance strategy.
Many on Wall Street noted that if this reform amounted to only minor administrative adjustments, it would have limited short-term impact on the $30 trillion Treasury market. However, if it involved significant changes to the Fed’s current securities portfolio of over $6 trillion, it could increase market volatility and raise deeper concerns about the Fed’s independence depending on the specific circumstances.
Looming over any negotiations between the Fed and the Treasury is Trump, who argued last year that one of the central bank’s responsibilities when setting interest rates is to consider the government’s debt costs. These costs are currently rising at a rate of about $1 trillion per year, equivalent to half of the budget deficit.
Will the Fed and Treasury collaborate on 'YCC'?
Tim Duy, Chief U.S. Economist at SGH Macro Advisors, commented on this potential agreement, stating, “A public agreement that explicitly synchronizes the Fed’s balance sheet with Treasury financing would closely link monetary operations to deficits… This doesn’t look like isolating the Fed; instead, it resembles a framework akin to Yield Curve Control (YCC).”
This was precisely the situation ended by the 1951 Accord. During and after World War II, the Fed kept federal borrowing costs low by capping yields on both short- and long-term Treasury bonds. However, this approach led to a surge in post-war inflation. Subsequently, the Truman administration—at a landmark moment affirming the Fed’s monetary policy autonomy—agreed to allow Fed policymakers to set interest rates independently.
Wash stated last April that the massive bond-buying spree initiated by the Federal Reserve after the financial crisis and the pandemic effectively violated the principles established in 1951. In interviews and speeches, he argued that these actions encouraged reckless government borrowing.
Bessent also criticized the Federal Reserve for maintaining quantitative easing (QE) for too long, claiming it even undermined the market's ability to send important financial signals. The U.S. Treasury Secretary, who has been responsible for identifying Powell’s successor over the past year, argued that the Fed should conduct QE 'only during genuine emergencies and in coordination with other parts of the government.'
Therefore, a new agreement might simply stipulate that—beyond routine liquidity management—the Fed could only engage in large-scale Treasury purchases with the approval of the Treasury Department, with the aim of halting QE as soon as market conditions permit.
However, involving the Treasury in the Fed’s decision-making could invite alternative interpretations. For instance, Krishna Guha, Head of Global Policy and Central Bank Strategy at Evercore ISI, noted, 'Investors would interpret this as Bessent having a ‘soft veto’ over any quantitative tightening (QT) plans.'
A more substantive version of the agreement would likely align with the expectations of most market participants: rolling over intermediate- and long-term Treasuries held by the Federal Reserve into short-term Treasury bills (with maturities of 12 months or less).
This would allow the Treasury Department to reduce the issuance scale of intermediate- and long-term Treasuries, or at least not increase issuance as originally planned. In its quarterly refunding statement released last Wednesday, the U.S. Treasury linked the Fed’s actions to its issuance plans, noting it is monitoring the central bank’s recent increase in Treasury bill purchases.
‘We are already on a path of close coordination between the Federal Reserve and the Treasury,’ said Jack McIntyre of Brandywine Global. ‘The question is whether this coordination will be amplified.’
Portfolio Shift
Others have proposed broader scenarios where the Federal Reserve under Wash would become part of a multi-phase plan aimed at reshaping the influence of federal agencies in the bond market.
Guha of Evercore ISI put forward a concept: the Federal Reserve could swap its $2 trillion mortgage-backed securities (MBS) portfolio with the Treasury for short-term Treasury bills.
Despite the multiple obstacles and questionable feasibility of the plan, one of its potential objectives is to reduce mortgage interest rates—a key focus for the Trump administration. Last month, Trump instructed government-controlled Fannie Mae and Freddie Mac to purchase $200 billion in mortgage-backed securities to help lower borrowing costs for potential homebuyers.
PIMCO’s global economic advisor and former Federal Reserve Vice Chair Richard Clarida wrote that the new agreement could “provide a framework over time for the Federal Reserve and the Treasury Department—and possibly housing agencies Fannie Mae and Freddie Mac—to work together to reduce the size of their balance sheets.”
Notably, some current Federal Reserve policymakers have previously supported the idea of shifting the central bank’s portfolio toward shorter-term Treasury bills, arguing that its substantial holdings of long-term assets no longer reflect market structures.
Deutsche Bank strategists predict that under Kevin Warsh’s leadership, the Federal Reserve could become an active buyer of Treasury bills over the next five to seven years. In one scenario, they estimate that Treasury bills could account for as much as 55% of its portfolio, up from less than 5% currently.
The cost cannot be overlooked.
However, the Treasury Department's shift toward issuing Treasury bills instead of interest-bearing bonds does come at a cost. The continuous rollover of massive debt will increase the volatility of the Treasury’s borrowing costs.
Regardless of whether an agreement exists, market participants are closely monitoring whether the relationship between the Federal Reserve and the Treasury Department in the bond market will become more aligned. While the goal may be to limit interest costs for various U.S. borrowers, any fundamental shift carries risks.
The risk lies in the possibility that investors may perceive the Federal Reserve’s actions as having diverted it from its mandate to combat inflation, thus increasing the likelihood of heightened volatility and rising inflation expectations. The worst-case scenario could undermine the attractiveness of the U.S. dollar and the safe-haven status of Treasury bonds.
Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle Investments, stated that if there were an agreement “suggesting that the Treasury could rely on the Federal Reserve to purchase part of its debt or specific segments of the yield curve in the foreseeable future, it would be highly, highly problematic.”
George Hall, a professor of economics at Brandeis University and a former researcher at the Chicago Fed, noted that direct coordination to suppress interest costs “may work in the short term.” However, in the long run, investors might opt for alternatives to U.S. assets.
"The market will eventually find a way to circumvent it, and over time, they will shift their funds elsewhere," he stated.
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