Wash may reshape the Federal Reserve's balance sheet through a "short-for-long" strategy, significantly shortening the duration without reducing the size of the balance sheet. According to Barclays analysis, to minimize market disruption, this would require the Treasury to maintain unchanged issuance levels of long-term bonds to the private sector while increasing the issuance of short-term bonds to meet the Fed’s new demand (a new agreement). However, even with this approach, it would lead to an increase in term premiums for both short- and long-term government bonds, thereby pressuring the Federal Reserve to counteract with "lower interest rates," potentially triggering unexpected investment shifts due to larger-than-anticipated rate cuts.
Wash believes that the Federal Reserve's balance sheet is "too bloated and has excessively long duration," hoping to coordinate with Treasury bond issuance to significantly shift the Fed’s holdings from long-term bonds to short-term bonds. This would lead to an increase in term premiums for both short- and long-term bonds, thereby pressuring the Fed to lower policy rates.
According to Storm Chasing Trading Desk, Barclays noted in its interest rate research report released on February 10:
To reduce the Fed's market intervention (Reduce the Fed's footprint) without triggering a liquidity crisis, the Fed may abandon pursuing a reduction in the total size of its balance sheet and instead focus on reducing portfolio duration by reinvesting maturing bonds into short-term Treasuries.
This "short-for-long" strategy may appear to be merely an asset swap, but in reality, it offloads significant duration risk (Duration Risk) back to the private market, which will lead to a repricing of term premiums in the market.
In order to offset the tightening of financial conditions caused by a sharp rise in long-end yields due to supply shocks, the Fed needs to cut short-end policy rates as a balancing measure. The core logic of the report is as follows:
I. Current situation unsustainable: Wash’s view of a "distorted" balance sheet
As of early 2026, the size of the Federal Reserve’s balance sheet was approximately $6.6 trillion, far exceeding the pre-pandemic level of $4.4 trillion and the pre-global financial crisis (GFC) level of $0.9 trillion.
Barclays pointed out that what the "hawkish" Wash finds even more intolerable is its structure:
1. Excessive scale: Reserve balances are close to $3 trillion, accounting for 12% of bank assets.
2. Overly long duration: The weighted average maturity (WAM) of the current Fed-held Treasury portfolio is about 9 years, compared to only 3 years before the GFC.
3. Imbalance in portfolio structure: The proportion of government bonds with maturities exceeding 10 years has risen to 40%, while T-bills account for only 7% of the government bond portfolio (compared to 36% prior to the Global Financial Crisis).
Warsh has made it clear: 'The Federal Reserve’s bloated balance sheet... can be significantly reduced.' He seeks to return to an era when the Fed had less market intervention.
II. Risk of a hard landing: Why can’t Quantitative Tightening (QT) simply be restarted in a crude manner?
If Warsh intends to reduce the balance sheet by simply halting Reserve Management Purchases (RMPs) or restarting Quantitative Tightening (QT), the risks would be extremely high.
The current banking system operates under an 'ample reserves' framework. Banks’ demand for reserves is driven by liquidity regulations (LCR), internal risk management, and payment requirements, which do not follow a straight line but rather a nonlinear and unpredictable curve.
As witnessed during the repo crisis of September 2019, once reserve levels hit a critical scarcity point, stress in funding markets can erupt instantaneously.
If the Federal Reserve were to forcibly shrink reserves, it could unexpectedly push the market into the 'steep part' of the demand curve, causing overnight funding rates to spike, triggering deleveraging panic, and ultimately forcing the Fed to re-enter the market to stabilize conditions, as occurred in March 2020. This would run counter to the original intent of balance sheet reduction.
III. Warsh’s 'Scalpel': Shortening duration by purchasing T-bills.
Given that outright asset sales are not feasible, Warsh’s alternative approach is to shorten duration.
Barclays outlined a core strategy: Instead of reinvesting maturing notes/bonds into similar assets, the Federal Reserve would reinvest them into short-term Treasury bills (T-bills) through secondary market operations.
Over the next five years, approximately $1.9 trillion worth of US Treasury bills/bonds will mature. If the Federal Reserve implements this strategy, its holdings of T-bills will surge from the current $289 billion to around $3.8 trillion in five years, accounting for 60% of its Treasury portfolio. The duration of the Fed's investment portfolio will decrease from nine years to four years, returning close to pre-GFC norms.
This would significantly reduce the interest rate risk on the Federal Reserve's balance sheet and create room for future policy operations.
IV. Key Game Theory: A 'New Accord' Between the Federal Reserve and the Treasury
The success of this strategy still requires cooperation from the Treasury Department. This brings up what Kevin Warsh referred to as the 'New Accord.'
Scenario A: The ‘Disaster’ of Lack of Coordination. If the Federal Reserve stops purchasing long-term Treasuries at auctions, and the Treasury fills the gap by increasing the issuance of long-term bonds (Coupons) to the private sector, the private sector will have to absorb an additional $1.7 trillion (in 10-year equivalent duration).
This would lead to a significant imbalance in the supply and demand of long-term US Treasuries, substantially pushing up term premiums (estimated to raise the 10-year yield by 40-50 basis points).
Scenario B: The Necessary 'Tacit Agreement.' The most reasonable path is for the Treasury to maintain a stable level of long-term bond issuance to the private sector while meeting the new demand from the Federal Reserve by issuing more T-bills. Under this scenario, the share of T-bills held by the private sector would stabilize at around 24%.
Although the average maturity of the Treasury’s overall debt would shorten (from 71 months to approximately 60 months), this would prevent market turmoil.
V. Endgame Analysis: A Steeper Yield Curve with Lower Interest Rates
Barclays cited a 2019 study by the Federal Reserve Board staff, which reached a counterintuitive but crucial conclusion: the shortening of the portfolio duration is tantamount to a disguised interest rate hike, thus requiring a reduction in policy rates to offset the impact.
The data model shows:
1. Increase in term premium: Even with the cooperation of the Treasury Department, the market would anticipate an increase in duration supply during the transition period, leading to a rise in term premium.
2. Rate cuts as compensation: Research indicates that, to maintain the same level of macroeconomic output (with unchanged inflation and unemployment rates), if the Federal Reserve adopts a short-duration portfolio, the federal funds rate would need to be 25 to 85 basis points lower than the baseline scenario.
Barclays pointed out that Warsh's balance sheet normalization is a multi-year process. During this process, investors will face: higher repo risk premiums (as the Fed attempts to test the reserve floor), higher term premiums (steepening yield curve), and a lower path for policy rates (to offset tighter financial conditions).
For investors, this means going long on the front end (betting on larger-than-expected rate cuts) while remaining cautious on the long end (demanding higher risk compensation).
Editor/KOKO
