Feb 2: Core Setup

My view is that the Fed transition creates a mispricing in short-end rates. The market is not fully pricing how much a Warsh-led Fed could change the reaction function.

This note lays out why I think ZQ is undervalued, what could break the trade, and what data I need to keep watching.

ZQM7 Comdty Curve as of late Jan

ZQM7 Comdty Curve as of late Jan

  1. Both Bessent and Warsh seem to trace part of their macro framework back to Stan Druckenmiller. Druckenmiller has criticized Fed policy ease and spent 2024 positioned short long-term bonds because of US debt and wealth-transfer concerns. If Warsh becomes Chair, I would expect tighter coordination between Treasury and the Fed on debt management, and I do not think the market is fully pricing that.

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M2 Supply Growth

M2 Supply Growth

  1. AI is deflationary in the way Warsh describes it. If the same amount of labor and input can produce more output, the result should be disinflationary over time.

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  1. Warsh's preferred mix of rate cuts and QT could be a viable way to handle three things at once: inflation, the short-term debt refinancing wall, and Fed independence. With Treasury facing large near-term refinancing needs at current rates, there is a fiscal argument for cuts that goes beyond the normal macro-cycle case.

The risk is liquidity. Powell's QT from 2017 to 2019 drained reserves from about $2.8tn to under $1.4tn, and the system broke before QT ended. A Warsh version of this policy could create a similar setup with even less room for error, especially with reverse repo near $1bn and the TGA around $290bn.

  1. Let's do a Fed count after Warsh. I don't see any good reason for J. Pow to stay; it is risky for his reputation and may cause difficulty on the transition to the new chair. I would definitely bet that he will be gone once the term ends, with either Warsh or another dovish appointee replacing him. You've got 4 out of 12 confirmed dovish votes. With QT on the back, I don't think a 3% target rate is very hard to sustain.

BOARD OF GOVERNORS (7 seats):

Dovish one

Warsh (Chair, Powell’s seat) Waller
Bowman
Miran

Centrist:

Jefferson
Cook