Kevin Warsh views the Federal Reserve's balance sheet as "excessively large and overly extended in duration." His proposed solution involves coordination with the Treasury Department, where the Fed would significantly shift its holdings from long-term to short-term Treasury securities. This maneuver is expected to drive up term premiums across the yield curve, ultimately pressuring the Fed to lower its policy interest rate.

According to analysis from Barclays in a February 10 interest rate research report: To reduce the Fed's market footprint without triggering a liquidity crisis, the central bank might abandon the goal of shrinking the overall size of its balance sheet. Instead, it could focus on shortening the duration of its portfolio by reinvesting proceeds from maturing bonds into short-term Treasury bills. While this "short-for-long" swap appears to be a simple asset substitution, it effectively transfers substantial duration risk back to private markets. This would inevitably lead to a repricing of term premiums. To counteract the tightening of financial conditions resulting from a significant rise in long-term yields due to supply shocks, the Fed would need to implement offsetting cuts to its short-term policy rate. The report's core logic is as follows:

I. An Unsustainable Status Quo: The "Malformed" Balance Sheet in Warsh's View

As of early 2026, the Fed's balance sheet stands at approximately $6.6 trillion, significantly larger than the $4.4 trillion pre-pandemic level and the $0.9 trillion pre-Global Financial Crisis (GFC) level. Barclays notes that the structure is particularly concerning for "hawkish" figures like Warsh: 1. Excessive Size: Reserve balances are near $3 trillion, accounting for 12% of bank assets. 2. Excessively Long Duration: The weighted average maturity (WAM) of the Fed's Treasury portfolio is currently about 9 years, compared to just 3 years before the GFC. 3. Imbalanced Holdings: The proportion of Treasuries with maturities exceeding 10 years has risen to 40%, while T-bills constitute only 7% of the portfolio (versus 36% pre-GFC). Warsh has explicitly stated that the Fed's bloated balance sheet "could be reduced significantly." He aims to return to an era of diminished Fed market intervention.

II. The Risk of a Hard Landing: Why a Simple Restart of QT is Problematic

If Warsh attempted to shrink the balance sheet simply by halting reserve management purchases or restarting quantitative tightening (QT), the risks would be substantial. The current banking system operates under an "ample reserves" framework. Bank demand for reserves is driven by liquidity regulations (LCR), internal risk management, and payment needs, forming a nonlinear and unpredictable demand curve. As experienced during the September 2019 repo crisis, once reserve levels approach a critical point of scarcity, funding market stress can erupt suddenly. Forcing a reduction in reserves could push the market unexpectedly onto the "steep part" of the demand curve, causing overnight funding rates to spike, triggering deleveraging panic, and ultimately compelling the Fed to intervene as it did in March 2020. This would contradict the original intent of balance sheet normalization.

III. Warsh's "Scalpel": Shortening Duration via T-bill Purchases

Since outright asset sales are not feasible, Warsh's alternative is to shorten the portfolio's duration. Barclays outlines a core strategy: The Fed would cease reinvesting proceeds from maturing notes and bonds into similar securities. Instead, it would reinvest those proceeds into short-term Treasury bills (T-bills) via the secondary market. Over the next five years, approximately $1.9 trillion in notes and bonds are set to mature. If the Fed executes this strategy, its T-bill holdings would surge from the current $289 billion to around $3.8 trillion in five years, comprising 60% of its Treasury portfolio. The duration of the Fed's portfolio would drop from 9 years to 4 years, nearing the pre-GFC norm. This would significantly reduce the interest rate risk embedded in the Fed's balance sheet and create room for future policy maneuvers.

IV. The Crucial Negotiation: A "New Accord" Between the Fed and Treasury

The success of this strategy hinges on coordination with the Treasury Department, leading to what Warsh terms a "New Accord." Scenario A: A Disastrous Lack of Coordination If the Fed stops purchasing long-term Treasuries at auctions, and the Treasury attempts to fill the gap by increasing long-term bond issuance to the private sector, the private sector would need to absorb an additional ~$1.7 trillion (in 10-year equivalent duration supply). This would create an imbalance in long-term Treasury supply and demand, substantially pushing up term premiums (estimated to increase the 10-year yield by 40-50 basis points).

Scenario B: The Necessary "Understanding" The most logical path is for the Treasury to maintain its current long-term bond issuance to the private sector while increasing T-bill issuance to meet the Fed's new demand. In this scenario, the private sector's share of T-bill holdings would stabilize around 24%. Although the Treasury's overall debt average maturity would shorten (from about 71 months to 60 months), this approach avoids severe market disruption.

V. The Endgame: A Steeper Yield Curve and Lower Rates

Barclays cites a 2019 study by Federal Reserve Board staff, arriving at a counterintuitive yet critical conclusion: Shortening the portfolio's duration is equivalent to a de facto tightening of policy, which must be offset by lowering the policy rate. The model indicates: 1. Rising Term Premiums: Even with Treasury cooperation, markets would anticipate increased duration supply during the transition, leading to higher term premiums. 2. Rate Cuts as Compensation: The study suggests that to maintain the same macroeconomic outcomes (unchanged inflation and unemployment), the federal funds rate would need to be 25 to 85 basis points lower under a short-duration portfolio strategy compared to the baseline.

Barclays concludes that Warsh's balance sheet normalization is a multi-year process. During this period, investors will face: higher repo risk premiums (as the Fed tests the lower bound of reserves), higher term premiums (steepening the yield curve), and a lower path for the policy rate (to offset tightening financial conditions). For investors, this implies a strategy of being long the front end (betting on more substantial rate cuts than expected) while maintaining caution on the long end (demanding higher risk compensation).