It’s hard to believe that February is already here. It is harder still to fathom how many market-making, and market breaking, headlines have hit the screens since we started the year. Among the many risk factors facing investors in 2026, Ally and I have placed US central bank independence at the top of the list. With all the fiscal and trade policy uncertainty out there, it was critical that there be a steady hand on the wheel at the Federal Reserve, if there was any chance of stocks or bonds having another decent year. Chair Jerome Powell ends his term in May and speculation has swirled as to who President Trump would submit to Congress for consideration.

Many believed it would simply be a lackey who would obediently support an agenda for significant interest rate cuts, thus injecting stimulus into a slowing economy in time for the mid-term elections. Last weekend, Trump announced he was officially nominating Kevin Warsh to the position of Chair of the Federal Reserve. Of the candidates, Warsh was viewed as the most experienced and perhaps steadiest, though there are some anxieties brewing among investors as we enter a new chapter that might be defined as "Lower for Now, Volatile for Later."

Before we get into the potential implications for markets and, more importantly, your pocket book, let’s take a step back and see what Mr. Warsh all is about. While he doesn’t hold a doctorate in economics, he has a law degree from Harvard and was a member of the Fed Board of Governors from 2006 to 2011. He played a key role during the Great Financial Crisis, tapping into his experiences on Wall Street and specifically Morgan Stanley. Where he fits into the disruptor-in-chief’s desire for lower rates is a little murky though.

Warsh is fundamentally an inflation hawk and even called for rate increases in the middle of crisis, so with CPI inflation above 2% for now five years (holding at 2.7% in December), one would think he is not going to be banging the drums for half-point rate cuts like Trump’s other appointees, Chris Waller and  Stephen Miran. On the other hand, Warsh is also known as a supply-side optimist, and he made the case that AI-driven productivity could allow for a much lower "neutral" rate. Maybe Trump has a rate-cutter in his corner after all. The problem is that if Warsh actually supported aggressive easing in rates, in the face of persistently elevated inflation, this would raise a red flag for markets in terms of Fed credibility.

This is not, however, the key risk that market participants have honed in on since his nomination. No, as much as Warsh is a firm believer in keeping inflation at bay, he has an even greater disdain for a bloated Fed balance sheet, which today stands at $6.6 trillion. He has advocated for a "regime change" that involves rapidly shrinking the Fed’s footprint—a process called Quantitative Tightening (QT). During the Global Financial Crisis, the Fed became the "buyer of last resort." Warsh argues that this "mission creep" distorted the market.

While I argued at the time that a zero-rate policy indeed would distort consumer behaviour (borrowing too much) and investment behaviour (reaching for return in places some had no experience with), the quantitative easing initiative was a necessary evil given that zero rates weren’t enough to restore financial stability. We went through a similar exercise with COVID and again, the immediate drive to zero on official rates and the massive expansion in the Fed’s balance sheet was not the best choice on the monetary policy menu. There is a difference, however, between avoiding past policy mistakes and turning over the table entirely. If the Fed were to truly engage in quantitative tightening on a scale that the market has not priced in, then there could be major repercussions for the bond market, equities and the economy.

There are two avenues for the Fed if it indeed opts to shrink the balance sheet. First, the Fed can simply let bonds on the balance sheet mature and instead of reinvesting the funds in new bonds, it just removes the money from the system. Second, the Fed can actually sell its government and mortgage-backed bonds into the open market, which again decreases the amount of money in the system. Like any other system that adheres to supply-demand physics, either of these measures which reduce liquidity will tend to push yields higher. The question is which yields?

To get a handle on this, let’s look at what types of bonds the Fed currently holds. As of the last reporting period, the average maturity of its holdings is around six years. About a fifth of its balance sheet is in short-term debt (T-bills), so the vast majority are in bonds that mature 2-years and out. For those of you that invest in GICs, think about this like a traditional 1–5-year ladder. In that system, every time a GIC matures, you simply invest the proceeds in another 5-year GIC.  What instead if you decided to reinvest in only 1-year GICs, or perhaps even 30-day cashable GICs? The average maturity would obviously decline. But what if you decided not to buy another GIC at all? What if you, like my late uncle in London did, just stuff the cash in a coffee tin perched on a shelf in the kitchen? That money isn’t circulating, so anyone looking for cash is going elsewhere. Less supply + same or higher demand = an increase in borrowing costs, or yields.

Now, without getting too bond nerdy, let’s have a look at some unforeseen consequences from a Fed that wants to shrink the balance sheet quickly. Unless you haven’t noticed, there hasn’t been a lot of fiscal austerity in the U.S., or elsewhere for that matter. Uncle Sam needs money and he isn’t shy about borrowing it. The Fed might not want to be the buyer of last resort anymore, but if it is going to reinvest maturing funds it is likely to do so in short-term debt (T-Bills). Perfect, Trump says. I will just borrow at the short end of the curve (I will wait for Scott Bessent to come off Fox News and let him know). A bunch of rate cuts by Mr. Warsh and the gang, and this is even better. Meanwhile, longer term bond yields are not coming down and may be going up because those darn bond investors. They just don’t like financing deficits for ten years or more, when fiscal discipline is a bedtime story, inflation is close to 3% and their big brother in Washington isn’t reinvesting back into those bonds.
 

Now, there has been a lot of talk about how this rise in longer term yields (meaning bond prices go down) won’t necessarily spark a big correction for two reasons. First, a lot of holders of longer-term US bonds do so in order to match assets with liabilities. A life insurance company, for example, has an educated idea as to how much it will pay out each year on claims and therefore aims to do its best to match assets with those claims. Just because someone in Washington has an idea to exit the long end of the bond market is not a reason to dump those securities. Other entities do own those bonds, and some paid a dear price back in 2023 after witnessing a major correction in long term bond prices after the inflation run-up and rate hikes of 2022. After that lesson, there are probably less that are vulnerable today, but some don’t learn their lessons.

Then there are those central banks outside of the U.S.  We typically think of the likes of China, Japan, Brazil, Russia and other large players, that hold tons of U.S. debt, getting ready to pull the trigger and sell massive amounts of long-term bonds into the market. They have some, but the majority of their holdings are actually relatively short-term. The problem now is that the Fed potentially is going to be a bigger player (buyer) of short-term debt, while perhaps engineering lower short rates. It is possible these foreign central banks will take a pass and instead of reinvesting the funds from maturities, deposit them elsewhere. That could reinforce a decline in the American greenback.

Okay, let’s bring the market talk back down to earth. How does all this affect our portfolio and our personal finances?  Well, if something is going to cause long-term bonds to underperform shorter dated bonds, then we probably don’t want to play there as much. For the past few months, Ally and I have been discussing the need to shift our thinking. In December, we made the strategic decision to cut our long-term bond exposure in our fixed income model. With the 10-year U.S. Treasury recently testing 4.30% and the 30-year hovering near 4.87%, that move is starting to look more like a necessity than a precaution.

Now, if long-term bond yields remain high or move higher, this will have an upward influence on long-term borrowing costs, like mortgages. Here, I see the risk as being greater in the U.S., where they have 30-year mortgage rates. If those rates move up, we will likely see the housing supply issue in the U.S. exacerbated as less households will want to move from a home that has a relatively low mortgage rate, only to take on a new mortgage with a higher rate. So much for affordability Donald. Here in Canada, our mortgage rates are going to be linked more to what happens in the 5-year bond area or less and we believe this segment of the curve should hold steady against the sell-off in long-term bond yields.

However, there is a limit. The spread between U.S. and Canadian 10-year yields is wide (U.S. at 4.30% vs Canada at 3.43%). If that spread widens too much, it could put downward pressure on the Canadian Dollar. To protect the Loonie, the Bank of Canada may eventually have to adopt a tightening agenda, which could move 5-year yields higher.

Bottom line. we are entering a phase where the Federal Reserve may go through a regime change, one which will create winners and losers. By trimming our long-bond exposure early, we have secured a defensive posture that allows us to look for opportunities as the curve finds its new normal. That said, if Warsh’s policies cause a global "term premium" reset that lifts all yields beyond the 2-year mark, Canadian bond investors will be impacted and households will still feel it at renewal. However, the U.S. consumer is far more exposed to the "long-bond" volatility that Warsh's balance sheet reduction might trigger, and that will take us full circle to the mid-terms.

Keep in mind that the voting members of the Federal Reserve’s Open Market Committee all have an opinion. Three of them might be under a Trump jedi mind trick, but to get a complete regime change, there is still a long way to go. Till then, Ally and I are watching the plumbing so you don't have to.

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.     

Andrew Pyle