After Trump nominated Kevin Warsh to be the next Federal Reserve Chairman, the market quickly bet on a more hawkish balance sheet policy, but Goldman Sachs believes the market may have misjudged.
Wall Street Insight mentioned that on January 30, Trump nominated former Federal Reserve Governor Kevin Warsh as the next Federal Reserve Chairman. Following the announcement, long-term bond yields rose slightly, the dollar rebounded, and precious metals plummeted. The market seems to be pricing in his &#34;hawkish&#34; views on the balance sheet.
However, recently, Goldman Sachs' trading and research teams have conducted in-depth analyses on Warsh, believing that the market may have once again misjudged the actual stance of the new Federal Reserve Chairman.
Goldman Sachs foreign exchange strategist Mike Cahill warned that judging Warsh's policy orientation solely based on his previous statements at the Federal Reserve is incorrect, pointing out:
<blockquote>
We know that at least being willing to cut rates is a prerequisite for him to get this job.
</blockquote>
Goldman Sachs Treasury trader BROWN stated that the trades of steepening the curve and narrowing swap spreads have been fully priced in, and Warsh's hawkish comments on the balance sheet are unlikely to translate into a restart of quantitative tightening policy. He said:
<blockquote>
This would be too destructive for risk assets.
</blockquote>
The market habitually misreads the initial stance of the new Federal Reserve Chairman, and every recent predecessor has experienced significant &#34;misleading&#34; in their first year in office. Investors are going through another cycle of &#34;misjudgment&#34; regarding the new Federal Reserve Chairman, and it will take time for the market to adapt to the new communication style.
<h2>Goldman Sachs Economist Mericle: Balance sheet reduction is difficult to advance, the institutional framework has become a settled fact</h2>
Goldman Sachs economist David Mericle outlined Warsh's core policy positions.
On interest rates, Warsh called for rate cuts last year, believing that the deregulation of the Trump administration and artificial intelligence are &#34;anti-inflation&#34; forces, and the Federal Reserve should not maintain high rates solely because of strong economic growth.
On the balance sheet issue, Warsh has been a long-time critic. He opposed the previous QE2, arguing that the massive balance sheet distorts the market, exacerbates inequality, and fuels inflation. He advocates combining rate cuts with balance sheet reduction to offset their impact on the financial environment.
Mericle pointed out that he does not believe Warsh will push for a significant reduction in the balance sheet. The core resistance lies in the broad and strong support within the Federal Reserve for the current &#34;ample reserves&#34; operating framework. Mericle stated:
<blockquote>
Federal Reserve officials have thought a lot about this over the past decade, and there is a strong preference for the current approach.
</blockquote>
Most Federal Reserve decision-makers and staff believe that the growth of the balance sheet relative to the size of the economy is an inevitable result of the accelerated growth of demand for Federal Reserve liabilities and the implementation of monetary policy under the ample reserves framework. Mericle emphasized that the current Chairman Powell just delivered a speech a few months ago outlining its advantages, which is seen as setting the tone for the debate.
Mericle believes that if Warsh wants to achieve balance sheet reduction without raising long-term interest rates, the only realistic path is to loosen bank regulations, such as adjusting liquidity coverage ratio rules to reduce banks' demand for reserves, but this requires time and coordination among multiple parties
On financial regulation, Warsh believes that the current system imposes excessive compliance costs on banks, especially small and medium-sized banks. He advocates for regulatory agencies to better support mergers among small and medium banks and calls for the establishment of a new regulatory system in the U.S. rather than fully adhering to the international Basel Accords.
<h2>Goldman Sachs Trading Frontline: Market Reaction May Have Been Overdone</h2>
Feedback from Goldman Sachs' global trading division generally downplays Warsh's influence.
Goldman Sachs U.S. Treasury Trader BROWN bluntly stated that trends reflecting expectations for balance sheet reduction, such as narrowing swap spreads and steepening yield curves, &#34;now seem to have been fully digested by the market.&#34; His intuition is that Warsh will not actually push for a restart of quantitative tightening, as it would be too destructive to risk assets.
Goldman Sachs Forex Strategist Mike Cahill pointed out a key contradiction: Warsh's past views are inconsistent with the realistic commitments required for his nomination. He believes:
<blockquote>
We know that being willing to cut rates is at least a prerequisite for getting this job.
</blockquote>
Cahill noted that the market's &#34;hawkish balance sheet&#34; trades based on his historical views make sense, but implementing them in reality will take longer.
Cahill further analyzed that the Federal Reserve's decision-making mechanism operates on a one-person, one-vote basis, and compared to the large turnover in the committee when Powell took office in 2017-2018, there are far fewer personnel changes now, meaning the new chair will need time to establish influence.
He predicts that future policy coordination between the Federal Reserve and the Treasury will increase, and Warsh may accept the Fed holding more short-term Treasuries, but it is unlikely to engage in &#34;twist operations.&#34;
Goldman Sachs' European Interest Rate Trading Head NIKHIL CHORARIA interpreted that Warsh's &#34;hawkish&#34; stance mainly reflects on the balance sheet, while his &#34;dovish&#34; side is evident in &#34;repairing&#34; the financial system structure to allow for lower policy rates.
He candidly stated that these views &#34;are difficult to reconcile with the goal of lowering long-term Treasury yields,&#34; which may need to be led by the Treasury.
European Rates Head WILL MARSH believes that the market's initial focus naturally fell on Warsh's past criticisms.
However, he emphasized that considering the Trump administration's recent focus on &#34;affordability,&#34; and the fact that the Fed itself just adjusted its balance sheet policy path at the end of last year, shifting to a framework that provides ample liquidity through the purchase of Treasury bills, the context is different. He concluded:
<blockquote>
The market's assessment of all this will ultimately depend largely on economic fundamentals.
</blockquote>
<h2>The Market Always Misjudges the New Chair, History Repeats Itself</h2>
Goldman Sachs specifically pointed out that the market's initial interpretation of Federal Reserve candidates often differs significantly from subsequent views.
Each recent predecessor has experienced some notable &#34;misleading&#34; moments in their first year, as they need time to adapt to the state where every word is interpreted, and the market also needs time to learn the new communication style.
Goldman Sachs Forex Strategist Mike Cahill cited specific examples: Powell's &#34;a long way to go to neutral,&#34; Yellen's &#34;in the next few meetings,&#34; and Bernanke's offhand comment to Maria Bartiromo about how the market views his testimony
Based on the comprehensive judgments of Goldman Sachs' internal economics and trading frontlines, Waller is a candidate with strong personal beliefs, but he faces an institution with significant policy inertia and institutional consensus.
For the market, this means that short-term news fluctuations surrounding personnel changes may be greater than actual policy shifts. Traders suggest that the potential profit space for yield curve trades based on Waller's &#34;balance sheet reduction&#34; view may be quite limited

Goldman Sachs foreign exchange strategist Mike Cahill stated that it is wrong to judge his policy orientation solely based on Waller's previous remarks, "being willing to cut interest rates is a prerequisite for him to get this job." Goldman Sachs economist Mericle pointed out that he does not believe Waller will push for a significant reduction in the balance sheet, as there is broad support within the Federal Reserve for the "ample reserves" framework. Goldman Sachs Treasury trader Brown bluntly stated that aggressive balance sheet reduction would be too destructive for risk assets

- Following Trump's nomination of Kevin Warsh as the next Fed Chair, markets have initially favored a hawkish balance sheet policy, leading to a rise in long-term bond yields and a rebound in the dollar.  
- Goldman Sachs analysts caution that the market may be misjudging Warsh's actual stance, emphasizing that historical perspectives do not necessarily align with necessary commitments to secure the position.  
- They conclude that market reactions are often exaggerated, and the anticipated changes may take time to materialize, as the Fed is constrained by established policies and internal consensus.

Wallstreetcn

GOLDMAN SACHS GROUP INC DEP SHR REP 1/1000TH PFD SER A

iShares 7-10 Year Treasury Bond ETF

GOLDMAN SACHS GROUP INC DEP SHS REPSTG 1/1000TH PRF SER C

Goldman Sachs

iShares barclays 20+ Yr Treasury Bd

ISHRS Us Brokers & Sec Exchg

ISHRS Us Trsry Bd

iShares 0-3 Month Treasury Bond ETF

GOLDMAN SACHS GROUP INC DEP REP 1/1000TH PRF D

Financial Select Sector SPDR Fund

VG Financial

iShares Core US Aggregate Bd

Fidelity MSCI Financials Index

iShares Barclays 1-3 Yr Treasury

SPDR Bloomberg 1-3 Month T-Bill ETF

Vanguard Total Bond Market ETF

iShares Barclays Short Treasury

How does Goldman Sachs view Walsh? The market consistently "misjudges" the new Federal Reserve Chairman, Walsh finds "quantitative tightening" very difficult, while interest rate cuts are a prerequisite for promotion