Warsh nomination as Fed chair raises bull-market unwind risk, analysts warn

The US stock market has spent the past month climbing to new records. The bond market, however, is starting to price a different future, one in which Kevin Warsh’s arrival as Federal Reserve chair on 15 May sets in motion forces that could unwind the rally equities are celebrating.

Warsh, President Donald Trump’s nominee to lead the central bank, is on track for Senate confirmation after the Banking Committee advanced his nomination on party lines. His agenda would reorient the Fed more than any chair since Paul Volcker: shrink the $6.7 trillion balance sheet, scrap the quarterly dot-plot forecasts, and negotiate a new Treasury-Fed accord that redefines the boundary between monetary and fiscal policy. Trump wants rate cuts by the June Federal Open Market Committee meeting. Warsh wants to shrink the Fed’s footprint first. The two goals may be incompatible.

The balance sheet that cannot shrink

Warsh has been consistent for 15 years. He resigned from the Fed’s Board of Governors in 2011 after the central bank failed to unwind its post-crisis asset purchases. In his April 21 confirmation hearing, he told senators the $6.7 trillion portfolio had “done quite a bit of harm” to the institution’s credibility.

Shrink the balance sheet, remove the hidden accommodation that props up financial asset prices, and create room to cut interest rates without overheating the economy. “If the printing press could be quiet, we could have lower interest rates,” Warsh said in a Hoover Institution interview last year, “because what we’re doing right now is we have all this money that’s being flooded into the system, which causes inflation to be above target.”

The Fed holds roughly $4.5 trillion in Treasury debt and just under $2 trillion in mortgage-backed securities. Shrinking the pile by waiting for bonds to mature works for Treasuries but barely touches the mortgage book. Most homeowners carrying 3 per cent mortgages from 2020 and 2021 have no reason to refinance, so the Fed’s MBS holdings roll off at a glacial pace.

Selling mortgages outright would shrink the portfolio within Warsh’s four-year term, but it would directly push up mortgage rates. The Trump administration is already running a parallel intervention: in January, the president asked Fannie Mae and Freddie Mac to buy $200 billion of MBS to push rates down. Warsh entering the market as a seller would repudiate that policy, a collision almost certain to end badly.

Bank reserves at the Fed sit at roughly $3 trillion. When reserves drifted to about $2.8 trillion on Halloween last year, the repo market seized up and banks borrowed record amounts from the Fed’s overnight backstop. The central bank not only stopped shrinking its portfolio in December. It began buying short-term Treasury bills within weeks to keep cash circulating. “Reducing the balance sheet without addressing reserve demand, to me, that’s just idiotic,” Fed Governor Chris Waller told CNBC. Warsh inherits a Fed that just discovered it had shrunk too much.

Kyla Scanlon, writing in The Dispatch, summarised the bind: “The easing Warsh wants to remove is mostly stuck in place, and the rate cuts Trump is quite loudly publicly demanding can’t really be justified by removing it.” Either inflation cooperates and gives Warsh cover to cut on the merits, or the balance sheet argument becomes cover for cuts with less comfortable motivations.

The independence question

Warsh has said the Fed should be “strictly independent” in setting interest rates. He then adds a qualifier without precedent in modern central banking: “Fed officials are not entitled to the same special deference in areas affecting international finance, among other matters.”

Six former Fed officials interviewed by CNBC described those comments as confusing at best and alarming at worst. One former high-level official, speaking anonymously, said: “If followed to its logical conclusion, the Fed could lose control of its balance sheet.”

Warsh’s proposed Treasury-Fed accord, a public agreement between the Fed chair and the Treasury secretary, would govern the size and composition of the balance sheet. Warsh frames it as a restoration of independence, shedding responsibilities that belong to elected officials. Powell-era officials see the opposite: giving Treasury a formal voice in monetary policy compromises independence rather than rebuilding it.

Jeffrey Lacker, the former Richmond Fed president and a longtime hawk, said he could welcome an accord that limited the Fed to buying only Treasuries. “I can also imagine a less constructive agreement that lets the Treasury use the Fed’s balance sheet to bypass Congress, perpetuating bad practices and compromising the Fed’s independence,” he said.

Treasury Secretary Scott Bessent confirmed that the United Arab Emirates and other Gulf states have requested dollar swap lines, the crisis-era tool the Fed used to calm global markets in 2008 and 2020. Warsh has signalled he views such decisions as Treasury’s territory, not the Fed’s. But swap lines are approved by the FOMC because they are monetary policy: they expand the balance sheet when drawn upon, adding almost $600 billion during the 2008 crisis alone, as former Boston Fed President Eric Rosengren noted.

Jim Bullard, the former St. Louis Fed president, said Bessent’s language about cooperation with the Fed “sounds like he’s talking about intimate cooperation. That’s usually associated with bad outcomes.”

What the bond market is saying

The 10-year Treasury yield has climbed from 3.95 per cent at the end of February to 4.44 per cent in early May. The 30-year bond has moved from 4.61 per cent to above 5 per cent. Some of that is the Iran war risk premium. Some is the sheer volume of supply: publicly held US debt has just topped 100 per cent of GDP, the Treasury must refinance more than $10 trillion in maturing obligations, and the federal deficit runs north of $2 trillion annually.

But part of the move is a verdict on Warsh’s agenda. The bond market is not pricing a successful balance sheet shrink that clears the way for sustainable rate cuts. It is pricing sticky inflation near 4 per cent, a Fed chair who may be less independent than his predecessor, and a fiscal trajectory that would consume half of all federal revenue in interest payments if the average rate on the debt reached 6 per cent, as Michael Pento of Pento Portfolio Strategies has noted.

The S&P 500 and Nasdaq continue to set records on AI and earnings optimism. The gap between equities and bonds, stocks pricing perfection while bonds price strain, is widening by the week.

The Powell factor

Jerome Powell, whose term as chair expires on 15 May, has chosen to remain on the Board of Governors until his seat term ends in January 2028. That breaks a 75-year norm: no former chair has stayed on as a governor since Tom McCabe in 1948. A former chair voting on the policies of his successor while the president who appointed both men demands rate cuts creates an awkward institutional dynamic.

JPMorgan chief US economist Michael Feroli offered the key caveat: “The other 11 members of the FOMC will act as a brake on any quick shift in monetary policy under Warsh.” The chair does not set rates alone. But the direction of travel, toward a smaller balance sheet, less transparent communications, and a Treasury-Fed relationship that blurs the line between monetary and fiscal policy, is set.

What happens next

Warsh’s first FOMC meeting as chair convenes on 16 June. Between now and then, three data releases will shape his opening move: the April consumer price index on 12 May, the April personal consumption expenditures index on 30 May, and the May jobs report on 5 June.

Cooling inflation would give Warsh room to deliver the rate cuts Trump is demanding while beginning the slow work of shrinking the balance sheet. Sticky prints close that door. The new chair would then face an early choice between the White House and the bond market. Arthur Burns, the last Fed chair who stared down that dilemma in the 1970s, chose to accommodate the president rather than defend price stability. It took Paul Volcker’s recession to repair the damage.

Deutsche Bank chief US economist Matthew Luzzetti noted that Warsh has called for “regime change” in Fed communications without specifying what replaces the current framework. That ambiguity may be deliberate. When a senator pressed him on whether sharp rate cuts would reignite inflation, Warsh did not answer directly: “The Fed has two important monetary policy tools. One is interest rates and the other is a balance sheet. Those tools should be working in concert, not across purposes.”

Equities have been running on AI optimism and earnings momentum. Bonds are pricing something closer to a reckoning.