The market is worried about Waller restarting QT? But the real tool may be SOMA

Trump nominated Kevin Warsh to be the next Chairman of the Federal Reserve, raising concerns in the market about balance sheet contraction. Although Warsh is known for his hawkish stance on the balance sheet, Citigroup believes that the likelihood of fully restarting QT (Quantitative Tightening) is low.

Citigroup analysts argue that what really deserves attention is the adjustment of the weighted average maturity (WAM) of the Federal Reserve's SOMA portfolio—by converting maturing securities into short-term Treasury bonds, the Federal Reserve can achieve a "slimming down" of its balance sheet without causing market turmoil. This strategy could release about $420 billion of reinvestment space between the second half of 2026 and 2027. For investors, this means the curve will steepen further, and the 3 to 5-year period may become the best "safe haven."

Warsh's Hawkish Stance: The Possibility of "Cutting" the Balance Sheet

Kevin Warsh, as a former Federal Reserve governor, has always held a tough stance on balance sheet issues.

In an article in The Wall Street Journal last November, he stated that the Federal Reserve's balance sheet is "bloated" and argued that it "can be significantly reduced. These generous resources can be redeployed in the form of lower interest rates."

The market's immediate reaction was as Citigroup expected—a steepening bull market (front end down, long end under pressure), with the 30-year swap spread further turning negative.

At the same time, the market began to price in slight rate hike expectations for 2027/2028, although Citigroup believes Warsh's historical focus on inflation risks is less relevant in the current environment.

SOMA Adjustment: A More Realistic Path than QT

Citigroup assesses that fully restarting QT will face significant resistance after last year's volatility in the repurchase market. A more likely operation is:

Reduction of Reserve Management Purchases (RMPs): from the current $40 billion per month down to about $10 billion (Citigroup expects it to naturally decline to $20 billion after mid-April). However, this has limited macro impact.

Adjustment of the WAM of the SOMA portfolio: Converting maturing U.S. Treasury securities into short-term Treasury bonds. Based on a monthly cap of $30 billion, approximately $140 billion could be achieved in the second half of 2026, and about $275 billion in 2027. This approach will gain broad support within the Federal Reserve.

Citigroup pointed out in its research report that the Federal Reserve may increase the proportion of short-term Treasury bonds in the SOMA holdings from the current level to 40%. This adjustment is technically easier to implement and will not cause a severe shock to reserve levels like a full restart of QT would.

However, analysts acknowledge that while the possibility of fully restarting QT is not the baseline scenario, it cannot be completely ruled out. This would require the Federal Reserve to first improve the clearing mechanism of the Standing Repo Facility (SRP) to dynamically replenish reserves. This would significantly reduce the WAM of the SOMA and increase the Treasury's financing needs.

Concerns About Term Premiums May Be Exaggerated

Citigroup believes that from the Treasury's perspective, any rollover of SOMA securities will increase its financing needs—either by issuing more short-term Treasury bonds or by increasing the size of the securities. However, if the Treasury continues to favor short-term bond issuance, the yield curve may not steepen significantly Analysts warn that the real risk lies in another "buyer strike" for U.S. Treasuries, which could be triggered by market panic over QT and/or an increase in the scale of future bond auctions (perhaps unreasonably).

Currently, there are concerns in the market that foreign demand may plummet, pushing up term premiums. However, Citigroup data shows that the foreign subscription ratio for last year's 10-year Treasury auction actually strengthened.

Typically, the strength of foreign demand for newly issued auctions depends on the performance of previous reopened auctions. The foreign subscription ratio for recently reopened auctions has been unusually high compared to newly issued auctions—this abnormal pattern suggests that foreign demand may remain strong for the next auction (tentatively scheduled for February 11)