Warsh's Fed balance sheet stance is “more noise than actual impact”

Overview

This report discusses how Kevin Warsh might adjust the Fed balance sheet if he were to become Fed Chair. BofA believes investors should focus on two dimensions: balance sheet size and asset composition. The conclusion is that a sharp reduction in size is unlikely, composition may change but with limited market shock, and the most important institutional question is whether Warsh would support ample reserves or scarce reserves; the report judges that he would support ample reserves.

Core views

First, after the Fed balance sheet is “normalized” through QT in 4Q25, its size will be determined mainly by the liability side, and among the three liabilities of currency, TGA, and reserves, currency and TGA are difficult for the Fed to actively compress, while reserves are the variable most likely to be influenced by Warsh. Second, directly imposing a cap on reserves or tiering interest on reserves would be bank-unfriendly approaches that could weaken banks' willingness to take risk, make markets, and extend credit, so Warsh is unlikely to adopt them. Third, the more likely path is bank-friendly liquidity deregulation, such as allowing banks to pre-position collateral at the Fed discount window and increasing HQLA usability, thereby reducing the need for reserve buffers. Fourth, on asset composition, natural MBS runoff with reinvestment into T-bills is already underway and absorbed by the market, while shortening the WAM of UST holdings is also unlikely to alter financial conditions because of the auction “add on” mechanism. Fifth, the report proposes a blue-sky option of bank SRP=IOR and reduced reporting on regional reserve distribution, arguing that this option could be more influential than traditional discussions.

Analysis framework

The report uses policy scenario analysis and money market microstructure analysis: it first breaks down the constraints on balance sheet size from the Fed liability side, then assesses the adjustability of currency, TGA, and reserves; it then analyzes the market transmission of MBS, UST reinvestment, and WAM shortening on the Fed asset side; finally, it evaluates potential institutional changes through the ample reserves framework, SRP tool design, and bank liquidity regulation.

Methodology notes

• Central bank balance sheet analysisFed balance sheet liability-driven framework

  Balance sheet size is constrained by the liability side

  The report argues that after balance sheet normalization, any further shrinkage must come from reducing major liabilities such as currency, TGA, or reserves; among these, currency is viewed as an exogenous liability, TGA is determined by Treasury preferences, and reserves are where policy has operational room.

• Money market regimeAmple reserves and scarce reserves framework

  Sensitivity of money market rates to changes in reserves

  Ample reserves means changes in reserves trigger only limited fluctuations in money market rates, whereas scarce reserves would cause larger volatility. The report judges that Warsh would most likely support ample reserves because it is easier to implement, reduces volatility, and supports relatively loose financial conditions.

• Bond market microstructureUST WAM and auction add-on mechanism

  The Fed's reinvestment method affects holdings WAM but does not necessarily affect market supply

  When the Fed reinvests maturing UST into newly issued UST, it is done through an auction add-on. If Warsh concentrates reinvestment into shorter maturities, the Fed's own WAM would decline, but if the Treasury does not offset it, the impact on the overall UST market and financial conditions could be close to zero.

• Liquidity tool designbank SRP=IOR blue-sky proposal

  Providing a standing repo facility to banks at the IOR level

  The report proposes that banks could borrow cash from the Fed against UST or agency debt collateral at the IOR level, and that reducing the stigma of using the facility could lower reserve buffer demand; this idea is not yet part of mainstream market discussion, but it could become a more influential policy path.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• UST

  Core vehicle for Fed asset-side reinvestment and WAM shortening

  Strengths

  Reinvestment into shorter maturities may accelerate the decline in the WAM of the Fed's UST holdings, but because it is executed through the auction add-on mechanism, market impact is expected to be limited.

  Weaknesses

  If the market misreads it as a change in the Treasury's supply structure, it could temporarily amplify yield curve volatility.

  Comparison

  Compared with direct asset sales, adjusting reinvestment maturity is more moderate and more predictable.

  Risks

  If the Treasury unexpectedly offsets the Fed's WAM shortening, it could change the report's assumption of near-zero market impact.

• Fed reserves

  Most likely adjustment item for balance sheet size compression

  Strengths

  Through bank liquidity deregulation, pre-positioning of collateral, and SRP tool design, reserve demand may decline gradually.

  Weaknesses

  The magnitude of the decline is limited and the pace is slow, making it difficult to support large-scale and rapid balance sheet reduction.

  Comparison

  Compared with compressing currency or TGA, reserves are more affected by the Fed and regulatory policy.

  Risks

  If bank-unfriendly measures such as a reserve cap or tiered IOR are adopted, financial conditions could tighten and banks' risk-taking could be suppressed.

• MBS

  One of the sources for returning the Fed's asset composition toward a UST portfolio

  Strengths

  Natural maturity and prepayment can gradually reduce the MBS share and redirect funds into T-bills.

  Weaknesses

  The pace is about $10-20bn/month, so the change is relatively slow.

  Comparison

  Compared with actively selling MBS, natural runoff is less likely to disturb the market.

  Risks

  If policy shifts toward actively selling MBS, it could bring volatility to mortgage spreads and duration markets, though the report considers that probability low.

• Money markets and repo

  The direct transmission market for changes in reserve demand, IOR, SRP, and RRP policy

  Strengths

  A more convenient bank SRP and lower stigma of usage could improve intraday liquidity and reduce reserve buffer demand.

  Weaknesses

  Tool design is complex and requires market acceptance as well as coordination with regulatory reporting rules.

  Comparison

  bank SRP=IOR is more market-based and has lower stigma than the traditional discount window.

  Risks

  If the foreign RRP rate or cap is adjusted, it could push cash out of the Fed into repo or bills, but it could also weaken the USD's reserve currency status.

Key data

• Three major liabilities of the Fed balance sheetCurrency, TGA, reservesThe report argues that further balance sheet reduction must work through these three liabilities, with reserves being the most realistic adjustment target.
• Expected TGA balanceAbout $900bn at end-2Q26 and about $950bn at end-3Q26The report believes the Treasury has limited willingness to reduce TGA, and that even if TGA repo or TT&L adjustments occur, the impact would be small.
• Potential impact of bank-friendly deregulation on reserve demandAbout $200-500bn, around 10% of the total, and at a slow paceThis mainly comes from pre-positioning collateral, expanding HQLA usability, and reducing banks' need to hold reserve buffers.
• Fed MBS holdings sizeAbout $2tnThe report says the Fed is allowing roughly $10-20bn per month of MBS to mature or prepay, and is reinvesting the proceeds into T-bills.
• Pace of natural MBS runoff and reinvestmentAbout $10-20bn/monthThe report believes this practice is already underway and priced by the market, and that Warsh is unlikely to create a shock by actively selling MBS.
• Spread assumption of dealer SRP relative to bank SRP and IORAbout 5-10bp higherThe report distinguishes bank SRP from dealer SRP and believes dealer SRP should be above bank SRP and IOR in order to preserve room for private repo market trading.

Impact & implications

In terms of investment implications, the report weakens the narrative that “Warsh will significantly shrink the balance sheet and clearly shock the rates market.” If his policy path mainly consists of bank-friendly deregulation and shortening the WAM of the UST portfolio, the initial effect may be lower funding rates or slightly easier financial conditions rather than tightening; without a tightening in financial conditions, this also does not constitute sufficient reason for Fed rate cuts. What truly merits attention is SRP tool design, whether the reserve demand curve shifts left, and whether the Treasury unexpectedly adjusts issuance to offset the Fed's WAM shortening.

Risks

• If Warsh chooses scarce reserves or adopts bank-unfriendly tools such as a reserve cap or tiered IOR, it could lead to money market volatility and tighter financial conditions.
• If the Treasury unexpectedly adjusts issuance structure to offset the Fed's UST WAM shortening, it could change the report's judgment that market impact would be close to zero.
• bank SRP=IOR remains a blue-sky proposal; implementation would require institutional design, reporting disclosure adjustments, and market acceptance, creating execution uncertainty.
• If the foreign RRP rate is lowered or a cap is imposed, it could weaken the USD's reserve currency status and harm U.S. national interests.
• Warsh may have a relatively high threshold for intervening in disorderly markets; if a shock occurs, there is uncertainty around policy response speed and market stability.

What to watch

• Whether Warsh establishes a Fed balance sheet working group, and whether the group focuses on size, composition, or liquidity tool reform.
• Whether the Fed expands pre-positioning arrangements for discount window collateral, or promotes deregulation of bank liquidity regulation.
• Whether the reserve demand curve shifts left, and whether funding rates continue to decline relative to IORB.
• Whether the TGA balance remains elevated as expected by the report, especially around about $900bn at end-2Q26 and about $950bn at end-3Q26.
• Whether the Fed adjusts UST maturity reinvestment rules to direct more funds into shorter maturities such as 2Y or 3Y.
• Whether the Treasury offsets the Fed's WAM shortening through issuance strategy.
• Whether the pace of natural MBS runoff and T-bills reinvestment remains around $10-20bn/month.
• Whether bank SRP=IOR, dealer SRP spreads, and adjustments to regional reserve distribution reporting enter formal policy discussion.