The Federal Reserve may find it difficult to reduce its balance sheet in the near term, but the threshold for resuming quantitative easing or continuous balance sheet expansion has also risen significantly. If the Fed is unwilling to support fiscal easing through balance sheet expansion, a potential temporary monetary-fiscal coordination approach could involve the Fed increasing the magnitude of interest rate cuts while the Treasury increases short-term debt issuance. This would first promote financial deregulation before commencing balance sheet reduction. The eventual scale of Fed rate cuts may exceed market expectations, and dollar easing trades could stage a short-term comeback. A steeper US Treasury yield curve combined with financial deregulation would benefit US bank stocks. The Federal Reserve will likely determine the endpoint of the gold bull market, but this inflection point has not yet arrived. Chinese equities and global commodities are only facing temporary pressure, awaiting the return of easing expectations.
The nomination of Warsh as the next Fed Chair has triggered significant volatility in global assets. Former President Trump unexpectedly nominated Warsh for the position last week. As Warsh advocates for a policy mix of "rate cuts + balance sheet reduction," markets perceive him as hawkish, leading to sharp reactions across asset classes. Gold and silver prices fell by up to 20% and 40% respectively, while Chinese stocks (listed in Hong Kong and mainland China) and global commodities experienced broad-based corrections, and the US dollar strengthened.
Over the past year, the AI technology wave and US dollar liquidity have been the two dominant themes driving global markets. The reshaping of the monetary order and a depreciating trend for the dollar, which fueled ample dollar liquidity, served as the fundamental pillar for the broad rally in gold and equities, and for Chinese stocks outperforming US stocks. If Warsh ultimately succeeds in shrinking the Fed's balance sheet, it could partially restore confidence in the US dollar, slow the de-dollarization trend, and tighten dollar liquidity. This would directly challenge the prevailing market theme of ample dollar liquidity and potentially reverse global market trends.
It is not advisable to linearly extrapolate Warsh's past policy stances into his future policy choices. Instead, it is crucial to consider political, economic, and financial constraints simultaneously, carefully assessing the feasibility of his proposals and projecting the potential sequence and focus of future policies. Our analysis suggests the new Fed's policy path might be more dovish than current market pricing implies. The theme of ample dollar liquidity is not yet fundamentally undermined, suggesting dollar easing trades may return shortly, while medium-to-long-term market trends require further confirmation.
Implementing balance sheet reduction in the short term appears challenging, but the barriers to renewed QE or sustained balance sheet expansion have also increased notably. The proposed policy combination of "rate cuts + balance sheet reduction" is a puzzling aspect of Warsh's stance. He explains that balance sheet reduction can lower inflation, thereby creating room for rate cuts. However, logically, balance sheet reduction is a tightening monetary policy, whose effects run counter to the direction of rate cuts and may also conflict with the Trump administration's goals of boosting economic growth and reducing debt costs, potentially facing political constraints.
More importantly are market constraints. Fed balance sheet reduction withdraws liquidity from the financial system, reducing bank reserve levels. When reserves become insufficient, banks may reduce their market-making activities in money markets and the Treasury market, leading to liquidity shortages within the financial system and even triggering financial risks. Following the previous balance sheet reduction cycle, US bank reserves are already at relatively low levels. A liquidity shortage occurred in the money markets last December, causing the spread between money market rates and the policy rate to widen, which prompted the Fed to switch from balance sheet reduction to expansion.
The period from 2017 to 2019 was even more extreme, where balance sheet reduction ultimately triggered a repo market crisis. Therefore, the current financial landscape does not support Warsh initiating balance sheet reduction in the short term.
Simultaneously, given Warsh's longstanding opposition to Fed balance sheet expansion, we believe that barring a financial crisis or other emergency, the Fed under his leadership may be reluctant to engage in QE or balance sheet expansion operations in the future. It will likely seek an appropriate时机 to commence balance sheet reduction, gradually moving away from the era of massive liquidity injection. Considering both political and financial constraints, a potential policy path could involve the Fed prioritizing rate cuts during the current presidential term and pursuing balance sheet reduction in the next presidential term.
Warsh's short-term policy focus is likely to be on interest rate cuts, and the magnitude of future Fed rate cuts may exceed market expectations. Former President Trump is eager for the Fed to lower rates, so further rate cuts align with political constraints. Concurrently, the administration needs to reduce debt costs. If Warsh is unwilling to pursue QE or balance sheet expansion, meaning the Fed would no longer directly monetize fiscal deficits, the existing US fiscal-monetary coordination mechanism for expansion would be broken. The Fed would need to support Treasury debt issuance in other ways. A potential interim measure could be for the Fed to implement larger rate cuts while the US Treasury adjusts its debt issuance structure towards more short-term Treasuries. Fed rate cuts would suppress short-term rates, and Treasury issuance of short-term debt would lower financing costs, thus mitigating the negative impact on long-term financing rates from insufficient QE/balance sheet expansion. In fact, the US Treasury has already begun increasing the proportion of short-term debt issuance, and there is room for further increases.
From an economic constraint perspective, we predict US inflation will rise in the first half of the year, potentially experiencing a "compensatory increase" in the coming months, but will turn downward again in the second half. Therefore, after Warsh potentially takes office in May, improving US inflation conditions might open the door for rate cuts.
In summary, the short-term policy focus of the next Fed is likely to be rate cuts rather than balance sheet reduction, leaning dovish rather than hawkish. There is even a possibility that the magnitude and pace of rate cuts could significantly exceed expectations. Recent market interpretation of Warsh simply as a hawk, expecting only two Fed rate cuts in the future, has led to significant corrections across asset classes, suggesting a substantial expectation gap may exist.
Another short-term policy focus for Warsh could be financial deregulation, to pave the way for future balance sheet reduction. As mentioned, US money market liquidity is a key constraint on balance sheet reduction, reflecting limitations imposed by the current financial regulatory framework on bank balance sheet usage. To proceed with balance sheet reduction without harming financial stability, financial deregulation might be necessary first, loosening constraints on bank balance sheet utilization, such as lowering leverage ratio requirements and risk weights.
Besides preparing for future balance sheet reduction, financial deregulation could help repair US Treasury market liquidity, indirectly lowering US financing costs. Increased volatility and decreased liquidity in the Treasury market in recent years, alongside reduced convenience yields, reflect both increased US macroeconomic volatility and issues related to the banking system's microstructure. Treasury market making consumes bank balance sheet capacity. However, since the pandemic, US Treasury debt has increased by $11 trillion, a 66% expansion, outpacing the growth of bank balance sheets, making it difficult for banks to meet market-making demands. Financial deregulation could enhance the efficiency of US bank balance sheet usage, lower market-making costs, help restore Treasury liquidity, and potentially lower rates by reducing liquidity premiums, aligning with Trump's objectives.
Looking ahead to 2026, the Fed's policy might initially appear hawkish before turning dovish, potentially exiting the "massive liquidity injection" model in the long run. We previously suggested that the Fed's rate-cutting cycle could unfold in "fast-slow-fast" stages. Warsh's nomination does not alter our view on the Fed's rate-cutting rhythm. Early 2026 is still expected to be the "slow phase" of rate cuts: we previously forecasted synchronized rises in US growth and inflation early in the year, leading to "temporary" economic overheating, causing the Fed to slow the pace of rate cuts, cooling easing expectations temporarily and posing a risk for asset corrections. Warsh's unexpected nomination merely brought forward the timing of cooled Fed easing expectations without changing the underlying trend.
Looking forward, the Fed's "fast rate-cutting" phase might also remain largely unaffected. Based on the analysis above, after the potential Fed leadership change in May, balance sheet reduction is unlikely to commence immediately; rate cuts will probably continue, potentially even exceeding expectations. Therefore, we believe that after hawkish expectations are fully priced in early in the year, dollar easing expectations could reheat. In the long term, if the Fed under Warsh gradually exits the "massive liquidity injection" model, it could help restore confidence in the US dollar, but policy uncertainty remains high, which is beyond the scope of this discussion.
It is important to note that the above analysis represents one probable policy path based on current limited information. Future Fed policy moves remain highly uncertain: whether Warsh's nomination is confirmed by Congress, potential divergence between the new Chair's actual policies and historical stances, collaboration with current Fed officials, and coordination with the President and Treasury could all significantly alter the future policy path. We will update our policy path and market expectations based on the latest information.
The Federal Reserve will likely determine the endpoint of the gold bull market, but this inflection point has not yet arrived, with short-term adjustments creating buying opportunities. We have clearly stated that before the Fed exits its easing policy or the US economy shows comprehensive improvement, the gold bull market is unlikely to end abruptly; the pace of central bank gold buying and the US debt outlook are not decisive factors. The "Warsh Shock," by altering Fed policy expectations and causing significant gold price volatility, confirms that Fed policy is indeed the most critical variable determining gold's prospects.
We disagree with the grand narrative that gold will continue to rise as long as global order tends towards chaos and US dollar hegemony weakens. Historical precedent, such as the 1970s following the collapse of the Bretton Woods system, saw gold rise nearly 20-fold over a decade amidst arguably more intense global monetary disorder changes. However, this epic bull market ended abruptly in the early 1980s when Volcker's Fed tightened monetary policy.
We believe the endgame scenario for this gold bull market is relatively clear. One possibility is the Fed ending its rate-cutting cycle and commencing balance sheet reduction. Another is significant progress in the US AI revolution, boosting growth and lowering inflation. As neither a Fed policy shift nor a fundamental US economic拐点 has occurred yet, we believe the gold bull market can persist for some time. We have consistently noted over the past two months that gold valuations appear expensive, and cooled Fed easing expectations early in 2026 could lead to correction risks. Strengthening US growth and inflation in the coming months might continue to dampen Fed rate cut expectations, causing market disturbances. Strategically, we recommend maintaining an overweight position in gold, using market pullbacks to accumulate positions.
US bank stocks could emerge as beneficiary assets from the "Warsh Shock." Firstly, if the Fed continues cutting rates without engaging in QE or balance sheet expansion, and even eventually reduces its balance sheet, short-term US Treasury yields are likely to fall relative to long-term yields, probably leading to a further steepening of the yield curve. Since banks typically "borrow short and lend long," a steeper yield curve helps improve bank profitability.
Secondly, financial deregulation, likely preceding balance sheet reduction, would also benefit the banking sector. Finally, even disregarding the impact of the Fed transition, stronger US growth and inflation data early in the year could lead the US into a "temporarily overheated" state. Banks, as traditional cyclical sectors, would also find support. In summary, we recommend an overweight position in US bank stocks.
The US dollar may strengthen temporarily, but whether the de-dollarization trend can be reversed remains to be seen. If the Fed under Warsh can gradually exit the "massive liquidity injection" model without triggering financial risks, it would help restore some confidence in the US dollar, providing support. In the short term, due to factors like the government shutdown, seasonal distortions in employment data, and compensatory effects on inflation statistics, the US economy might experience "temporary" overheating early in 2026.
Widening growth differentials between the US and other economies, coupled with a slower pace of Fed easing in the first half of 2026, suggest the US dollar could be relatively strong in the short term.
However, over the medium to long term, Trump's policies, involving fiscal expansion that amplifies US balance sheet risks and the "weaponization" of tariffs impacting the international order, may continue to erode confidence in the US dollar. Whether the Fed under Warsh can fully offset the erosion of dollar credibility caused by Trump's policies remains to be tested by time. Therefore, the reshaping of the international monetary order and de-dollarization remain our base case scenario. We expect the dollar to re-enter a downward trajectory after a phase of strength.
Chinese equities and global commodities are facing temporary pressure; investors should consider buying on dips, awaiting the return of easing expectations. The "Warsh Shock" has also affected Chinese stocks and commodities. Regarding Chinese equities, typical bull market top signals have not yet appeared; positive factors like ample liquidity and marginal improvements in earnings have not fundamentally changed. Over the medium to long term, monetary order restructuring and AI industry trends remain core drivers. We maintain a firm positive outlook on the revaluation of Chinese assets, recommend an overweight position in Chinese stocks, and suggest using market volatility to build positions.
For Chinese bonds, constrained by the "stock-bond跷跷板 effect," temporary supply-demand imbalances for long-duration bonds, and expensive valuations, the risk-reward profile appears relatively limited, recommending an underweight position.
Regarding commodities, they can hedge against risks of temporary US economic overheating and geopolitical risks, and also possess potential for further gains once easing trades return. Recommend increasing allocations during recent adjustments, seizing medium-term布局 opportunities.
For overseas assets, US stocks have shown more resilience than Chinese stocks under the "Warsh Shock," consistent with our view on the dollar liquidity theme: non-US stocks exhibit greater elasticity relative to US stocks—they outperform when dollar liquidity is ample and underperform when liquidity expectations tighten. Considering US stocks remain expensively valued and the theme of ample dollar liquidity is not yet reversed, we recommend a market-weight position in US stocks, with an structural overweight in cyclical sectors like banks that benefit from temporary economic overheating and the Warsh impact.
For US Treasuries, temporary economic overheating and rising inflation may continue to pressure the bond market in the short term. However, as rate cuts potentially re-accelerate, short-term rate declines seem more certain. Recommend a market-weight position overall, adopting a curve steepening strategy.
US inflation may experience "compensatory increases" in the first half of the year, with data for February and May potentially偏高, before turning downward in the second half. Our forecast for the US inflation path is a key basis for projecting the Fed's potential "hawkish first, dovish later" stance this year. We systematically analyzed three sources of偏差 in US October-November inflation data, predicting compensatory monthly increases potentially in December 2025, January 2026, and April 2026. Combined with the ongoing pass-through of tariff costs from businesses to consumers, US year-on-year inflation may continue rising in the first half of 2026.
The December 2025 US headline CPI was below market expectations, but certain components subject to bi-monthly统计 did show clear compensatory effects. The overall low reading was due to historically very low values in some other core services components, whose negative contribution outweighed the positive contribution from compensatory effects, resulting in a low headline CPI despite the bi-monthly rotation compensation. Therefore, we believe the推升 effect of statistical lag on inflation data will continue to manifest in the January 2026 inflation data.
However, entering the second half of 2026, we expect US inflation to enter a downward cycle. Downward pressure on economic growth may become more apparent, weighing on services inflation and countering the upward push from tariffs on goods inflation. Breaking it down by component: - The pass-through of tariff adjustments on goods inflation (19% weighting) will likely be completed by H1 2026. The impact of tariffs on inflation is primarily a one-time price level adjustment rather than a sustained rise in the inflation中枢. If the US Supreme Court overturns Trump's "reciprocal tariffs," the inflation increase could be smaller and shorter-lived; this warrants close attention. - Rent CPI inflation (36% weighting) growth may slow again after April 2026. Due to statistical lags, rent CPI is expected to see a compensatory jump in April 2026 but should subsequently resume its downward trend. Current market rent measures show continued year-on-year declines, indicating the medium-term trend for slowing rent inflation remains intact. - Other core services inflation (13% weighting) may continue to cool alongside further labor market moderation. While Trump's immigration restrictions reduce labor supply, demand is also weakening simultaneously. Recent shifts in the labor market towards surplus supply and明显下行 wage growth suggest other core services inflation growth could continue to slow.