Kevin Warsh, while campaigning for the position of Federal Reserve Chair, outlined a series of policy proposals for his potential leadership. Among these was a suggestion to establish a "new accord" with the Treasury Department. Although viewed by Wall Street as somewhat obscure, this proposal could have profound implications. Warsh publicly supported creating a new version of the 1951 Accord to redefine the relationship between the Fed and the Treasury. The original agreement had strictly limited the Fed's involvement in the bond market. However, the landscape has drastically changed following the global financial crisis and the COVID-19 pandemic, accompanied by trillions of dollars in securities purchases. Consequently, when Trump nominated the 55-year-old Warsh for the next Fed Chair, market investors began extensively debating his true policy intentions.
Before Warsh, a former Federal Reserve Governor, might officially take office, neither he nor Treasury Secretary Scott Bessent has disclosed specific details of any potential agreement. Nevertheless, the nominee mentioned in an interview last year that a new accord could "clearly and prudently define" the size of the Fed's balance sheet, while the Treasury would clarify its debt issuance plans. Such an improvement might ultimately prove to be minor bureaucratic adjustments, having little short-term impact on the $30 trillion U.S. Treasury market. However, if it involves more significant measures, such as restructuring the Fed's current securities portfolio exceeding $6 trillion, it could lead to increased market volatility and, depending on the specifics, heighten concerns about the Fed's independence.
Any negotiations between the Fed and the Treasury would occur under the influence of Trump, who last year argued that one of the Fed's responsibilities in setting interest rates was to consider the government's debt costs. The government's annual interest expense on its debt is currently around $1 trillion, equivalent to half the budget deficit. "This doesn't look like isolating (protecting) the Fed; it looks more like a framework for yield curve control," said Tim Duy, Chief U.S. Economist at SGH Macro Advisors, commenting on the potential accord. "A public agreement synchronizing the Fed's balance sheet with Treasury financing explicitly ties monetary operations to the deficit." This is precisely the situation the 1951 Accord ended.
During and after World War II, the Fed had capped yields on both short-term and long-term Treasury securities to keep federal borrowing costs low. However, this approach contributed to soaring post-war inflation. Subsequently, the Truman administration—in a watershed moment for Fed monetary policy independence—agreed to let policymakers set interest rates autonomously. Warsh stated last April that, following the financial crisis and the pandemic, the Fed had effectively violated the 1951 principles through massive bond-buying waves. He argued in interviews and speeches that these actions encouraged reckless government borrowing.
A Milder Version Bessent has also criticized the Fed for maintaining quantitative easing (QE) for too long, arguing it even impaired the market's ability to send crucial financial signals. The Treasury Secretary, overseeing the review process for Powell's successor, advocates that Fed QE should be conducted "during genuine emergencies and in coordination with other parts of the government." Therefore, a new accord might simply stipulate that—aside from daily liquidity management—the Fed would only engage in large-scale Treasury purchases with Treasury approval, aiming to cease QE as soon as market conditions allow. However, involving the Treasury in Fed decision-making in this manner could invite other interpretations.
"Investors would interpret this as Bessent having a 'soft veto' over any quantitative tightening (QT) program," said Krishna Guha of Evercore ISI. A more substantive version of the accord would align with many market participants' expectations: a shift in the Fed's Treasury holdings from five-year and longer-term maturities towards short-term bonds (with maturities of 12 months or less). This would allow the Treasury to reduce sales of medium-term notes and long-term bonds, or at least not increase issuance as much as otherwise planned. In its quarterly debt management statement on Wednesday, the Treasury linked Fed actions to its issuance plans—noting it is monitoring the Fed's recent increase in short-term T-bill purchases.
"We are already on a path of close coordination between the Fed and the Treasury. The question is whether this coordination will amplify," said Jack McIntyre of Brandywine Global. The risk is that investors might perceive the Fed's actions as a deviation from its inflation-fighting mandate, increasing the potential for heightened volatility and rising inflation expectations. A worst-case scenario could undermine the dollar's appeal and the safe-haven status of U.S. Treasuries. Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle Investments, stated that if an agreement "implies the Treasury can count on the Fed buying a certain percentage of debt or Treasuries of a specific maturity for the foreseeable future, that would be extremely, extremely problematic."
Market Skepticism If confirmed before Chair Powell's term ends, Warsh could potentially take office in May and might seek to avoid such outcomes. "Warsh will be committed to preserving Fed independence. This doesn't rule out enhanced collaboration but lowers the probability of a formal agreement," said Mark Dowding, Chief Investment Officer at RBC BlueBay Asset Management. Others envision broader scenarios where the Fed is just one part of a multi-step reform plan aimed at reshaping federal influence in the bond market.
Krishna Guha, Head of Central Bank Strategy at Evercore ISI, suggested an idea where the Fed swaps its $2 trillion mortgage-backed security (MBS) portfolio with the Treasury for short-term bonds. While facing significant hurdles and likely proving improbable, one objective could be to lower mortgage rates—a priority for the Trump administration. Last month, the President directed government-controlled Freddie Mac and Fannie Mae to purchase $200 billion in MBS to help reduce borrowing costs for potential homebuyers.
A new accord could "provide a framework for the Fed, collaborating with the Treasury and potentially even housing agencies like Fannie Mae and Freddie Mac, to shrink its balance sheet size over time," wrote Richard Clarida, PIMCO Economic Advisor and former Fed Vice Chair.
Portfolio Adjustment Warsh almost certainly cannot unilaterally strike a deal with Bessent. However, some current Fed policymakers support the idea of shifting the central bank's portfolio towards short-term T-bills, arguing that its large exposure to long-term assets no longer reflects market structure. Deutsche Bank strategists predict that a Warsh-led Fed could become an active buyer of short-term Treasuries over the next five to seven years. In one scenario, they project the share of short-term Treasuries in its holdings could rise from less than 5% currently to as high as 55%.
However, a corresponding Treasury shift towards selling more short-term debt instead of coupon-bearing securities is not without cost. It would increase the volatility of Treasury borrowing costs as massive debt is constantly rolled over. "In a Warsh-Bessent world, the reduction of the Fed's balance sheet could be mapped onto a predictable Treasury debt schedule, giving markets clear visibility on liquidity and supply," said macro strategist Michael Ball. "If Treasury issuance plans and the Fed's balance sheet path are communicated as stable and reliable over the long term, it could avoid unexpected tightening of financial conditions and limit any unwarranted shocks in the rate market."
Regardless of a formal agreement, market participants are closely watching whether the relationship between the Fed and the Treasury in the bond market will become more synchronized. While the goal might be to limit interest costs for various U.S. borrowers, any fundamental shift carries risks. Direct coordination to suppress interest costs "might work in the short term," said George Hall, economics professor at Brandywine University and former Chicago Fed researcher. But in the long run, investors have alternatives to U.S. assets. "People will find ways around the system, and over time, they will take their money elsewhere," he said.
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