- The energy price shock will delay the Fed’s single rate cut in 2026. Rising energy prices should push US inflation towards +3.6% y/y in April-May, up from +2.8% expected before the Middle East conflict, under the assumption that oil prices remain around 90 USD/bbl on average in Q2. Despite a still weak labor market, the Fed will have to keep rates on hold at least through the summer amid risks of de-anchoring inflation expectations. We continue to expect only one 25bps rate cut this year, but pushed out to September.
- Fed chair nominee Kevin Warsh combines a dovish view on interest rates with a hawkish approach to the Fed’s balance sheet, which could drain liquidity from a highly leveraged financial system. Increasing frictions in the US money market would have a global impact on financial markets mainly though the channels of FX and interest-rate volatility. Warsh opposed additional rounds of quantitative easing (QE) in the 2010s, warning that prolonged asset purchases fueled financial excess and risked inflation. With hindsight, his concerns about loose financial conditions and asset valuations appear partly validated. But reducing the Fed balance sheet drastically or even returning to a scarce-reserves regime would ignore the intermediation mechanisms on which the US funding market has been founded since the GFC. The critical point is not the amount of reserves but the dealers’ balance sheets available to warehouse Treasuries and intermediate repo flows. Dealers face regulatory limits that are capping the size of their balance sheets. They cannot do both: absorb heavy Treasury issuance and provide smooth funding for the private sector. It would drive up prices for hedging instruments (swap spreads and cross-currency basis) but in a worst-case scenario such mismatch could trigger a deleveraging spiral affecting valuations of risky assets and increasing default risk for highly leveraged entities (e.g. hedge funds). The Treasury and the Fed have options to mitigate this, but it would require a massive easing of leverage regulation and/or a substantial decrease in Treasury issuance, the first being more likely than the latter.
- We expect the Fed to move cautiously towards a modestly smaller balance sheet from Q4 2026 at the earliest, keeping Treasury holdings steady while continuing the run-down of the USD2trn MBS holdings. This would limit money-market volatility but still risk higher mortgage rates. Wars typically involve monetizing deficits, i.e. restarting QE and departing from Warsh’s pledges for rapid quantitative tightening (QT). The Fed will likely adopt a hybrid model: a leaner balance sheet combined with standing repo facilities as permanent liquidity backstops, preserving rate control while mitigating systemic funding risks. Regulatory moves on bank liquidity regulations could also support the transition toward lower bank’s reserves. We would expect banks’ reserves balances to drop gently from 9.5% of GDP currently to reach the level of the 2019 money-market meltdown (below 7% GDP) only by Q4 2028, though uncertainties are large and episodes of money market volatility will likely become more frequent. The MBS reduction would however blunt the administration’s attempts to lower mortgage rates. The conflict in the Middle East could also drastically change the course of monetary policy in the US. In a downside scenario, quantitative easing may be needed to help finance the effort of the war.