- The energy market price shock will delay the Fed’s only expected rate cut in 2026. Rising energy prices are likely to push US inflation up to +3.6% y/y in April and May, compared with +2.8% expected before the outbreak of the conflict in the Middle East, assuming oil prices average around USD 90/bbl in Q2. Despite the still-weak labor market, the Fed will have to keep rates unchanged at least until the end of summer because of the risk of inflation expectations becoming unanchored. At Allianz Trade, we still expect only one 25bp rate cut this year, but shifted to September.
- Fed chair candidate Kevin Warsh combines a dovish stance on interest rates with a hawkish view on the Fed’s balance sheet, which could drain liquidity from a highly leveraged financial system. Rising tensions in the US money market would have a global impact on financial markets, mainly through exchange-rate volatility and interest-rate channels. Warsh opposed additional rounds of quantitative easing (QE) in the 2010s, warning that prolonged asset purchases create excess capital and inflation risks. In hindsight, his concerns about overly loose financial conditions and asset valuations appear partly justified. However, a drastic reduction of the Fed’s balance sheet, or even a return to a scarce-reserves regime (a scarce-reserves regime is a system in which the central bank keeps only as much cash, or reserves, in the banking system as commercial banks need to meet legal requirements), would mean ignoring the intermediation mechanisms on which the US funding market has relied since the Global Financial Crisis (GFC). The key issue is not the amount of reserves, but the balance-sheet capacity of dealers available to “warehouse” Treasuries and intermediate repo flows. Dealers face regulatory constraints that limit the size of their balance sheets. They cannot do two things at once: absorb large Treasury issuance and provide smooth financing for the private sector. This would raise the cost of hedging instruments such as swap spreads and cross-currency bases, but in the worst-case scenario such a mismatch could trigger a deleveraging spiral, affecting risky-asset valuations and increasing default risk among highly leveraged players such as hedge funds. The Treasury Department and the Fed have tools to mitigate this, but it would require either large-scale easing of leverage regulations and/or a significant reduction in Treasury issuance, with the former more likely than the latter.
- At Allianz Trade, we expect the Fed to begin cautiously pursuing a moderate balance-sheet reduction no earlier than Q4 2026, keeping its Treasury holdings unchanged while continuing to run down its USD 2trn mortgage-backed securities (MBS) portfolio. This would limit money-market volatility, but would still carry the risk of higher mortgage rates. Wars typically involve deficit monetization, i.e. a resumption of quantitative easing (QE), moving away from Warsh’s calls for rapid quantitative tightening (QT). The Fed will likely adopt a hybrid model: a “leaner” balance sheet combined with standing repo facilities as permanent liquidity backstops, enabling it to maintain control over rates while reducing systemic funding risk. Changes to bank-liquidity regulations could also support the transition toward lower reserve levels. At Allianz Trade, we expect bank reserves to decline gradually from the current 9.5% of GDP, reaching the 2019 money-market-crash level (below 7% of GDP) only in Q4 2028, though uncertainty is high and episodes of money-market volatility are likely to become more frequent. However, the reduction of the MBS portfolio will likely weaken the administration’s efforts to lower mortgage rates. The Middle East conflict could also radically alter the direction of US monetary policy. In a pessimistic scenario, QE may become necessary to finance the war effort.
The energy market price shock will delay the Fed’s only rate cut in 2026
The Fed will likely keep interest rates unchanged at its upcoming March 18 meeting in the face of inflationary pressure, which according to our analysis will peak at 3.6% in April or May. The conflict in the Middle East puts the Fed in a difficult position, as inflation is set to accelerate because of higher energy prices while labor-market conditions still appear fragile. In February, nonfarm payrolls fell by 92,000, and although part of this decline was due to strikes in the healthcare sector, private-sector employment excluding healthcare was still shrinking. However, with inflation having remained above the 2% target for five years, the Fed clearly cannot afford to focus primarily on labor-market risks. Inflation expectations are especially sensitive to energy (and food) prices and could become unanchored if the Fed is seen as too lenient toward inflation risks. At Allianz Trade, we expect the Strait of Hormuz to reopen by the end of April. In the meantime, partial restoration of supply, additional production (Russia, the US) and the use of strategic reserves should cover more than 50% of the oil and gas supply gap, limiting oil prices to an average of USD 90/bbl in Q2 2026. We estimate that the US energy CPI will rise from +0.4% y/y in February to a peak of around +15% in April. Core inflation would rise from +2.4% to a peak of +3.6% in April-May (Chart 1).
At Allianz Trade, we still expect one 25bp rate cut this year, but shifted to September. We have long assumed that the Fed’s room for rate cuts in 2026 would be limited, and before the Middle East conflict erupted we expected only one cut in June – a much more hawkish position than what financial markets were pricing in. We now expect the Fed to wait until September, when inflation should begin to fall, though it will likely remain above target. The labor market will probably remain weak and may deteriorate further during the summer as higher inflation eats into household incomes and some corporate profit margins. If the Fed holds its fire for now and keeps rates unchanged, the risk of second-round effects in prices amplifying the initial energy-price shock may be lower than in 2022.
Chart 1: US CPI inflation forecast (left)
Sources: LSEG Datastream, Allianz Trade Research
Pressure from Kevin Warsh to shrink the Fed’s balance sheet could intensify…
Kevin Warsh, President Trump’s nominee for Fed chair, has reassured financial markets thanks to his impressive track record and his reputation for prudence in monetary policymaking. Warsh, who is expected to take office in May, served on the Fed Board from 2006 to 2011, at the peak of the Global Financial Crisis (GFC). At the time, he supported aggressive monetary action to stabilize markets. However, as the recovery gathered pace, he opposed the second and third rounds of quantitative easing (QE) and resigned in 2011, reportedly because of differences over continued asset purchases. Importantly, Warsh’s concerns about QE focused on the blurring of the boundary between monetary and fiscal policy. He warned about financial-stability risks, speculative bubbles and inflationary pressure resulting from an expanded balance sheet. In hindsight, many of Warsh’s views have proven correct: financial conditions have been very loose since the Global Financial Crisis, equity markets have remained strong, financial risk has accumulated and inflation has risen, although later than he expected. Other critics of the Fed’s balance-sheet policy include Treasury Secretary Bessent, whose criticism focuses on the Fed’s net operating losses from paying interest on bank reserves – although Bessent is not pushing for a sharp balance-sheet reduction. More recently, in 2025, Warsh argued in an op-ed in favor of a significant reduction in Fed assets.
However, Warsh’s hawkish views on the balance sheet go hand in hand with a more dovish stance on interest rates. Warsh argues that monetary policy is too restrictive for small businesses and calls for lower interest rates. He believes that strong GDP growth stems from a positive supply shock – especially related to artificial intelligence – which should have disinflationary effects that would be reinforced by the administration’s deregulation agenda. In addition, in 2025 Warsh wrote that the Fed “should abandon the dogma that inflation is caused by excessive economic growth and excessively high worker wages,” signaling limited concern about demand-driven inflation pressure. He also suggested that the “generosity” of the balance sheet “could be converted into lower interest rates to support households and small and medium-sized enterprises.” Although the operational implications remain unclear, this may point to a preference for shifting away from asset purchases toward more direct credit-support mechanisms.
Warsh’s criticism of the Fed’s oversized balance sheet may find support among FOMC members. The Fed has already significantly reduced its balance sheet from its 2022 peak of 35% of GDP to below 20% through the runoff of its asset portfolio of Treasuries and mortgage-backed securities. All Treasury maturities have been shortened except for long-term bonds (Chart 2, left). Before the Global Financial Crisis, the Fed’s balance sheet averaged close to 5% of GDP, when it operated under a just-in-case reserve system rather than an excess-reserve system: bank reserve balances were essentially zero before the GFC (Chart 2, right). At the end of 2025, following strains in the repo market, the Fed launched reserve-management purchases (RMP), i.e. purchases of short-dated Treasuries (T-bills), in order to rebuild reserve balances. These T-bill purchases are partly financed through reinvestments of repayments from mortgage-backed securities (MBS) and longer-dated Treasury debt. However, there have been some differences among FOMC members regarding how far the Fed should increase its purchases, with the minutes noting that “several participants added that effective standing repo operations could allow for a smaller balance sheet.”
Chart 2: Main liabilities of the Fed’s balance sheet (mainly bank reserves and currency in circulation) (left); Fed Treasury holdings by maturity (right) – USD bn
Sources: LSEG Datastream, Allianz Trade Research
…but it would be a risky strategy with limited benefits
A move toward a smaller balance sheet would create financial-stability risks because the monetary-policy system has shifted away from fine-tuning reserves toward private-sector intermediation. The current balance-sheet policy based on abundant reserves is the result of structural changes triggered by the Global Financial Crisis. Before 2007, the Fed operated a scarce-reserves corridor system in funding markets characterized by large-scale unsecured lending, small dealer balance sheets, loose leverage constraints (pre-Basel III), off-balance-sheet repo transactions and a limited role for nonbank entities such as money-market funds and hedge funds in supplying cash. After the collapse in liquidity during the Global Financial Crisis, the Fed expanded its balance sheet through large-scale asset purchases, creating such an excess of reserves that the corridor system could no longer be managed through finely calibrated open-market operations, and it assumed the role of market-maker of last resort. The structure of the US funding market shifted from a system in which banks arbitraged small reserve shortages via interbank lending to one in which pricing is determined by administrative rates and central-bank facilities, while balance-sheet-constrained dealers intermediate between nonbanks and the Fed. As a result, the system’s critical constraint has shifted from the quantity of reserves to the dealer balance-sheet capacity available to warehouse Treasuries and intermediate repo flows. If balance-sheet capacity is constrained, market liquidity may still be poor despite abundant reserves. Returning to the pre-GFC scarce-reserves system would not be a “return to what worked for decades,” but rather an act of ignoring the intermediary nature of the US funding market. The current floor system based on abundant reserves, together with interest on reserve balances (IORB) and standing facilities (overnight reverse repo ON RRP, standing repo facility SRF), is a key pillar of central banks’ efforts to limit volatility in the post-GFC era. Today, changes in reserve levels have only a minimal impact on money-market spread movements. Under the previous scarce-reserves regime, a 1% change in reserve levels could trigger a response in market spreads of as much as 3–4 basis points (Chart 3). Returning to scarce reserves with daily open-market operations would create volatility and disruptions in market rates because intermediation capacity, not simple reserve management, is now the key point of friction.
Figure 3: Elasticity of reserve demand: response of the spread between EFFR* and IORB to a 1% change in reserves
The elasticity of reserve demand measures the sensitivity of market spreads (the difference between the effective fed funds rate and IORB, and between SOFR and IORB) to changes in the supply of reserves – in other words, the slope of the reserve-demand curve. When market frictions are low, this slope is close to zero and spreads barely move. When monetary transmission is impaired, the curve becomes steeper and small shocks to reserve supply lead to large changes in money-market spreads. In 2009, a 1% increase in reserves narrowed market spreads by 3–4 basis points, while today the impact is just 0.15 basis points. The elasticity of the SOFR-IORB relationship is more volatile because it reflects transmission between the unsecured money market and the secured, collateral-based market.
*EFFR = effective federal funds rate
Sources: LSEG Datastream, Allianz Trade Research
Eliminating interest on reserves (IORB) would have more negative than positive effects, making it unlikely. Alongside the debate about the Fed’s balance sheet, there is also debate over removing interest on reserves. IORB is intended to steer banks’ behavior by guaranteeing them an administratively set rate of return on their reserve balances. The costs and benefits of this system are politically controversial. Critics view IORB as a subsidy to the US banking sector. The Fed, by contrast, sees IORB as the price of maintaining the flow of bank credit. Removing IORB “would be extraordinarily disruptive” because it would impair the Fed’s control over short-term interest rates, reduce the volume of transactions intermediated by banks and therefore reduce private-sector liquidity. It would also create enormous money-market volatility and pressure short-term rates lower, because banks would replace reserves with alternative interest-bearing assets such as newly issued Treasuries or the Fed’s reverse repo facility (RRP, which acts as the lower bound of the policy-rate corridor). Replacing reserves with Treasuries would increase banks’ liquidity risk and raise Basel III capital requirements, increasing banks’ demand for central-bank liquidity and thus counteracting efforts to shrink the Fed’s balance sheet. A shift toward RRP would also reduce banks’ net interest margins, constrain their lending capacity and curb credit supply to the economy. Given these adverse consequences, the costs of eliminating IORB would outweigh the fiscal benefits.
The Fed is already operating under conditions of scarcity
The Fed faces a funding paradox in which a large balance sheet coexists with constrained intermediation capacity. Although the discussion centers on reserve scarcity, we find that the Fed is already operating under scarcity conditions – but from the intermediation side. Intermediation in funding markets refers to the willingness and ability of dealers and banks – constrained by balance-sheet requirements and subject to regulatory leverage and liquidity limits – to act as brokers between cash-rich nonbanks (money-market funds, pension funds, etc.) and collateral-rich issuers (the US Treasury, corporations, etc.). In the QE era, balance-sheet constraints rarely constituted a critical barrier. With QT, excess liquidity has fallen and dealer balance-sheet capacity has shrunk, along with their ability to absorb debt. This remains true today. As Treasury issuance, especially T-bills, occupies an increasing share of dealers’ limited balance sheets, financing becomes more expensive for other investors, particularly those running leveraged, risky strategies such as basis trades and asset swap spreads. Chart 4 illustrates the effect of the balance-sheet shortage: the more Treasury issuance rises, the more dealers must increase their inventories on their books. Their cost of carry is reflected in the risk premium represented by the asset swap spread, as well as in increased demand for cash visible in the spread between SOFR and Fed Funds (SOFR can be seen as the price of balance-sheet capacity), as well as in short-rate volatility.
Chart 4: Illustration of the balance-sheet-capacity shortage
Sources: LSEG Datastream, Allianz Trade Research
The Fed’s recent decision to resume purchases of short-term US Treasury securities (T-bills) should be viewed as a response to this shortage; the move is intended to serve as cash support for absorbing the huge issuance needs of the US Treasury. If the intermediation shortage persists, we are likely to see further Fed interventions, mainly via the SRF and further asset purchases. The probability of Fed intervention is linked to the ratio of bank reserves to total bank assets. Above 10%, reserves are considered abundant; below 10%, they are considered ample; while 8% means reserves are scarce. As shown in Chart 5, when the market reaches a level of absorption stress, the Fed typically intervenes and restores market liquidity. These interventions are often accompanied by announcements of new facilities (such as the SRF in September 2019) or programs (such as the BTFP after the Silicon Valley Bank crisis in March 2023).
Chart 5: Fed intervention framework – the price of money, reserve levels and usage of the SRF standing repo facility
Sources: LSEG Datastream, Allianz Trade Research
The Fed is shifting from being a structural provider of liquidity to acting as a safety valve, while the balance sheet plays a more limited role. The problem is that nonbank players, especially leveraged hedge funds, are not “plugged into” the Fed’s safety valves. Higher and more volatile repo rates combined with tighter haircuts on collateral could force them to unwind risky leveraged strategies such as basis trades and sell Treasuries into a less liquid market, amplifying price moves and volatility. Such a destabilizing deleveraging spiral was seen, for example, in March 2020. The Treasury Department and the Fed have ways to mitigate these risks. Significant easing of leverage regulations such as the SLR and ISLR could relieve some balance-sheet constraints and free up cash that would ease liquidity pressure. A significant slowdown in Treasury issuance could also free up balance-sheet capacity, but this remains unlikely. In any case, both solutions would only be temporary.
The Fed could lose control over global volatility
US money markets are the main providers of liquidity and leverage across the global financial system. When spreads in US money markets widen and volatility rises due to pressure on SOFR, the main transmission channels become FX swaps and interest-rate swaps (IRS). In FX swaps, this happens because the same intermediaries use their limited balance sheets to price currency derivatives. As a result, intermediaries can pass on the cost of balance-sheet constraints through higher risk premia to end users, leading to greater currency volatility and a wider cross-currency basis, as well as appreciation of the US dollar, which in turn tightens global financial conditions.
The interest-rate-swap transmission channel works through Treasury issuance dynamics. Swap spreads reflect liquidity at specific maturities as well as the banking system’s absorption capacity. If newly issued debt is not absorbed sufficiently by the private sector, primary dealers (banks) are legally required to hold it on their books, which affects their ability to finance the private sector. Negative swap spreads are a sign that issuance absorption is constrained. This reduces demand for long-term instruments, widens bid-ask spreads, lowers trading volumes and causes the yield curve to flatten or steepen. This effect is amplified by massive hedge-fund positions in Treasury basis trades (long cash bonds, short futures), financed in US money markets. Official CFTC data indicate a total volume of USD 1.3trn, with the net short position in US basis trades amounting to USD 1trn (Chart 6).
Chart 6: Hedge funds hold a minimum net short position of USD 1,000bn in US Treasury futures
*net open interest value in USD for leveraged funds according to CFTC (Commodity Futures Trading Commission) data
Sources: LSEG Datastream, Allianz Trade Research
Low money-market liquidity therefore creates the risk of a fixed-income selloff and increases the risk of a mass deleveraging spiral. The US Treasury market is currently more exposed to this risk because hedge funds have become the marginal buyer of US Treasuries since the US yield curve, once FX-hedged, has become relatively unattractive for foreign investors. Hedge funds, however, are not buy-and-hold investors; they use US Treasuries as collateral to borrow cash in the repo market in order to finance leveraged positions such as yield-curve arbitrage, swap spreads, credit spreads, bond-backed securitized products, cryptocurrencies and equity indices. This demand from leveraged investors lowers implied volatility across many asset classes and helps explain extremely low global volatility. But this mechanism works only as long as money-market rate volatility remains suppressed. That is why any change in the Fed’s monetary-policy framework would be highly risky (Chart 7).
Chart 7: Volatility suppression is linked to monetary and fiscal policy
Sources: LSEG Datastream, Allianz Trade Research
How would a global volatility shock unfold?
The pass-through of rising money-market-rate volatility would occur through higher risk premia, which could negatively affect leverage, hit risky-asset valuations and increase the risk of defaults in both the banking and nonbank systems. The process would unfold as follows:
First, a margin call triggered by rate volatility would create sudden refinancing demand and, as a result, a selloff in leveraged assets. Niche and peripheral assets such as leveraged cryptocurrencies and highly leveraged ETFs would likely correct first.
Second, default risk would rise among leveraged investors, especially hedge funds. Because these funds typically finance themselves through the sponsored repo market[1], sponsoring banks would ultimately have to step in and protect the clearing house if hedge funds failed.
This procyclicality is the result of the “active Treasury issuance” (ATI) strategy. Its aim is the large-scale issuance of T-bills to release excess liquidity generated by QE and parked in the reverse repo facility (RRP), in order to offset the restrictive effects of QT. However, this aggressive T-bill supply has also increased the potential for leveraged trades by nonbank entities such as hedge funds. ATI has therefore helped fuel asset prices and suppress volatility. So far, we do not see stress in the sponsored repo market, but volumes point to a mild deleveraging trend since the start of the year.
The deleveraging risk from the nonbank sector is amplified by additional layers of leverage: collateral transformation and collateral re-use.
Collateral transformation is the practice whereby counterparties swap lower-quality assets such as investment-grade corporate bonds for high-quality assets such as US Treasuries in bilateral over-the-counter markets. These transactions take place off balance sheet, and their scale is difficult to estimate.
Collateral re-use (rehypothecation) occurs when dealers re-use pledged collateral they have received, creating “collateral chains” in which the same asset passes through multiple transactions. This is common practice – it is estimated that around 85% of collateral received by the largest primary dealers is re-used.
In a mass selloff scenario, collateral re-use could trigger a chain reaction across markets that the Fed’s liquidity backstops could only partially contain, because the phenomenon occurs outside the central bank’s sphere of influence – in the nonbank sector or in uncleared segments of dollar money markets (the eurodollar system).
The Fed will reduce its balance sheet at a slower pace
Given these market vulnerabilities, at Allianz Trade we expect the Fed to move onto a balance-sheet reduction path very cautiously, no earlier than Q4 2026. Treasury holdings could remain unchanged, while the Fed may continue to run down its USD 2trn mortgage-backed securities (MBS) portfolio. Instead, the Fed would rely more heavily on standing repo facilities as permanent liquidity backstops, allowing it to maintain control over interest rates while reducing systemic funding risk as reserves decline.
Changes to bank-liquidity regulations, such as lower liquidity requirements that include bank reserves, could support the transition toward a smaller balance sheet and lower reserve levels. This would preserve financial-market stability but would carry the risk of higher mortgage rates. At Allianz Trade, we expect it will take time for Warsh to convince a majority of FOMC members to begin shrinking the balance sheet. Most likely, a compromise will be reached around keeping total Treasury holdings constant rather than shrinking them further, while allowing the MBS portfolio to continue rolling off at its current pace of around USD -17bn per month.
In this baseline scenario, at Allianz Trade we would expect the Fed to begin reducing its balance sheet in Q4 2026. Bank reserves would fall from the current 9.5% of GDP to below 7% in Q4 2028 – close to the level seen during the 2019 money-market disruption. In other words, with a cautious reduction path, it would take some time before the Fed potentially faces money-market volatility caused by lower reserve levels. Forecasting, however, involves considerable uncertainty. In particular, if nominal GDP were to grow faster than Allianz Trade expects, we could see bank reserves decline as a share of GDP more quickly.
Chart 8: Bank reserves at the Fed and Fed assets (Treasuries + MBS), % of GDP
Sources: LSEG Datastream, Allianz Trade Research
[1] The sponsored repo market consists of centrally cleared repo transactions in which a dealer bank introduces non-dealer clients such as hedge funds or money-market funds to the Fixed Income Clearing Corporation’s central clearing platform, allowing those clients indirect access to centrally cleared repo transactions, while the dealer guarantees performance of their obligations.
