Waller supports it, with far-reaching implications! After 75 years, the Federal Reserve is about to reach an agreement with the U.S. Treasury again?

With Trump's nomination of Walsh as the next Federal Reserve Chairman, a core issue he has long advocated is drawing significant attention on Wall Street: calling for a new agreement between the Federal Reserve and the U.S. Treasury to reshape the relationship between the two institutions. This concept aims to emulate the historic agreement of 1951, which could impact the $30 trillion U.S. Treasury market and fundamentally change the way the Federal Reserve manages its balance sheet.

On February 9, Bloomberg reported that although specific details have not been disclosed, Walsh has previously indicated that such an agreement should "clearly and thoughtfully describe" the size of the Federal Reserve's balance sheet and align with the Treasury's debt issuance plans. Meanwhile, U.S. Treasury Secretary Yellen has also expressed skepticism about the long-term implementation of quantitative easing (QE), suggesting it should only be used in emergencies and with government coordination.

The report highlights that the focus of market participants' debate is whether this is merely a bureaucratic adjustment or a significant restructuring of the Federal Reserve's current securities portfolio of over $6 trillion. If it involves a large-scale adjustment of the asset portfolio, it could trigger increased volatility in the $30 trillion U.S. Treasury market and raise deep concerns about the independence of the central bank.

It is noteworthy that the annual interest cost of the current U.S. government debt is about $1 trillion, which has intensified speculation in the market that the Federal Reserve might assist in fiscal financing through some form of "yield curve control," thereby directly affecting inflation expectations and the attractiveness of dollar assets.

Returning to 1951? Walsh's Policy Concept

According to reports, Walsh has proposed numerous policy ideas during his campaign for the Federal Reserve Chair, among which the most obscure yet impactful for Wall Street is his call for a new agreement with the Treasury. Walsh has expressed support for a new version of the "1951 Agreement" to fundamentally reform the relationship between the two institutions.

The historical 1951 Agreement greatly limited the Federal Reserve's footprint in the bond market, established the central bank's autonomy in monetary policy, and ended the practice during and after World War II of the Federal Reserve capping Treasury yields to lower federal borrowing costs.

However, Walsh pointed out last April that the trillions of dollars in securities purchases implemented by the Federal Reserve during the global financial crisis and the COVID-19 pandemic actually violated the principles of the 1951 Agreement. He argued in interviews and speeches that these actions encouraged reckless government borrowing.

Walsh stated in a CNBC interview that a new agreement could clearly define the size of the Federal Reserve's balance sheet while allowing the Treasury to set its debt issuance plan.

Yellen's Position and "Soft Veto Power"

The report notes that Treasury Secretary Yellen shares Walsh's stance in criticizing long-term quantitative easing. Yellen has accused the Federal Reserve of maintaining QE for too long, even undermining the market's ability to send important financial signals.

As a key figure responsible for selecting Powell's successor, Yellen advocates that the Federal Reserve's QE policy should only be implemented in "genuine emergencies" and in coordination with other government departments.

Therefore, a "streamlined" new agreement might stipulate that, apart from daily liquidity management, the Federal Reserve can only conduct large-scale Treasury purchases with the Treasury's approval and commit to ceasing QE as soon as market conditions allow However, Krishna Guha of Evercore ISI pointed out that this way of involving the Treasury in Federal Reserve decision-making could lead to other interpretations. Investors may perceive this as meaning that Bessenet has a "soft veto" over any quantitative tightening (QT) plans.

Portfolio Shift: From Bonds to Bills

In addition to adjustments in the policy framework, the market generally expects a more substantive agreement that may involve a significant shift in the Federal Reserve's asset holdings structure: specifically, moving from medium- and long-term securities to Treasury bills (T-bills) with maturities of 12 months or less.

This shift would allow the Treasury to reduce the issuance of notes and bonds, or at least not increase the issuance as significantly as before.

In the quarterly debt management statement released last Wednesday, the U.S. Treasury linked the Federal Reserve's actions to its issuance plans, stating that it is closely monitoring the central bank's recent increase in Treasury bill purchases.

Jack McIntyre of Brandywine Global stated, "We are on a path of closer coordination between the Federal Reserve and the Treasury, the question is whether this coordination will amplify further."

Reports indicate that strategists at Deutsche Bank predict that the Federal Reserve, under the leadership of Waller, may become an active buyer of Treasury bills over the next five to seven years. In one scenario, they expect the proportion of Treasury bills in the Federal Reserve's holdings to rise from currently less than 5% to 55%.

However, if the Treasury correspondingly shifts to selling Treasury bills instead of interest-bearing securities, it will face the risk of a massive debt rollover, which could increase the volatility of the Treasury's borrowing costs.

Market Risks and Concerns About Independence

Reports suggest that while enhanced coordination may aim to lower interest costs for U.S. borrowers, any fundamental shift comes with risks. Tim Duy, chief U.S. economist at SGH Macro Advisors, warned that:

An agreement to synchronize the Federal Reserve's balance sheet with Treasury financing explicitly ties monetary operations to the deficit, which is less about isolating the Federal Reserve and more like a framework for controlling the yield curve.

Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle Investments, bluntly pointed out that if the agreement implies that the Treasury can expect the Federal Reserve to purchase some debt or certain parts of the yield curve in the foreseeable future, "that would be extremely, extremely problematic."

The worst-case scenario is that investors perceive the Federal Reserve's actions as deviating from its mission to combat inflation, thereby raising volatility and inflation expectations, and potentially undermining the attractiveness of the dollar and the safe-haven status of U.S. Treasuries.

Some Experts Are Skeptical About the Likelihood of a Formal Agreement

Beyond the Treasury market, some experts have proposed broader ideas. Guha of Evercore ISI suggested the idea of the Federal Reserve exchanging its $2 trillion mortgage-backed securities (MBS) portfolio for Treasury bills with the Treasury Although this faces many obstacles, one of its goals may be to lower mortgage rates, which is also a key focus area of the Trump administration. Former Federal Reserve Vice Chairman Clarida of Pimco also pointed out in an article that the new agreement could provide a framework for collaboration between the Federal Reserve and the Treasury, and even housing agencies like Fannie Mae and Freddie Mac, to reduce the size of the balance sheet.

However, Mark Dowding, Chief Investment Officer of RBC BlueBay Asset Management, believes that Waller may be committed to maintaining the independence of the Federal Reserve, "which does not rule out strengthening cooperation, but reduces the likelihood of reaching a formal agreement."

George Hall, an economics professor at Brandeis University, warned that direct coordination to lower interest costs "may be effective for a time," but in the long run, investors have alternatives to U.S. assets.

"People will find ways to circumvent this, and over time, they will move their money elsewhere."