Citrini, a rising research institution, predicts a new agreement between the U.S. Treasury and the Federal Reserve, which could ignite U.S. debt crises in a few months.

Citrini, a rising research institution, predicts a new agreement between the U.S. Treasury and the Federal Reserve, which could ignite U.S. debt crises in a few months.

A quiet policy coordination between the U.S. Treasury and the Federal Reserve is being seen as a potential catalyst for a rise in long-term U.S. Treasury bonds.

In its latest report, leading research firm Citrini Research points out that the Treasury and the Federal Reserve are moving towards a more coordinated policy framework. The core logic is to shift government lending focus to short-term bonds and reduce the supply of long-term Treasury bonds, thereby paving the way for a rise in 30-year Treasury yields. Citrini calls this framework a new "Treasury-Fed Accord," and the firm has already advised clients to bet on 30-year Treasury yields outperforming 5-year Treasury yields, i.e., to go long on the narrowing yield spread between the two.

Founded by James Van Geelen, Citrini rose to prominence earlier this year with a "dystopian" report depicting an economic collapse driven by artificial intelligence, establishing itself as one of the most watched independent research firms in the market.

The immediate trigger for this judgment was Treasury Secretary Bessant's unexpected announcement last week of plans to increase the repurchase of long-term bonds. Under what Bessant called "Operation Twist," the government may replace some long-term debt with short-term Treasury bills to alleviate market pressure caused by the 30-year Treasury yield climbing to a near 20-year high. Citrini predicts that within the next three months, around the time of the Treasury's next refinancing announcement on November 4, the yield spread between 5-year and 30-year Treasury bonds will narrow significantly, at which point the effects of "Operation Twist" will be fully apparent to the market.

New agreement framework: Federal Reserve shrinks balance sheet, banks expand balance sheet, and long-term debt supply contracts.

Citrini’s core argument rests on three interlocking policy variables: bank regulatory reform, adjustments to the Treasury’s debt management strategy, and a shift in the Federal Reserve’s balance sheet policy.

The institution believes that under the new framework, the Federal Reserve will continue to shrink its balance sheet, while commercial banks will expand their balance sheets to absorb more short-term Treasury bills. At the same time, the Treasury will shift its bond issuance focus from long-term to short-term maturities, directly reducing the market supply of long-term US Treasury bonds. This contraction in supply will provide support for a decline in long-term yields.

Citrini wrote, "We expect that the monetary and fiscal authorities—Federal Reserve Chairman Warsh and Treasury Secretary Bessant—have agreed on a framework that aims to achieve multiple objectives simultaneously: reducing the Fed's presence in financial markets, improving fiscal sustainability, and stimulating economic growth by loosening restrictions on banks' lending and investment capabilities."

Walsh's role: Jackson Hole's speech is highly anticipated.

Federal Reserve Chairman Warsh is a key figure in this narrative. According to Bloomberg, Warsh is scheduled to deliver a major speech at the annual Jackson Hole symposium on Friday. He has long advocated for shrinking the Fed's balance sheet and has established a special task force to review its size and portfolio duration structure.

Warsh had previously spoken publicly about the idea of a new "Federal Reserve-Treasury Agreement," but did not disclose specific details. Citrini pointed out that the original 1951 agreement granted the Federal Reserve greater independence and ended the policy of suppressing government borrowing costs by limiting bond yields. The new agreement takes a different approach, focusing more on policy coordination than on reaffirming independence.

The banking sector benefits: the "biggest winner" of liquidity rule reforms.

Citrini believes that reforms to liquidity regulations will be a crucial complement to this framework. Relaxing liquidity requirements will allow banks to hold less cash, thereby freeing up more lending capacity. The agency named four large banks as the "biggest winners": Bank of America, U.S. Bancorp, Truist Financial Corp., and Capital One Financial Corp.

Citrini points out that Bank of America purchased a large amount of low-interest mortgage-backed securities between 2020 and 2021, and subsequent interest rate increases caused the book value of these bonds to shrink. "Because liquidity rules measure bonds at fair market value, the buffer narrows," forcing the bank to turn to securities-backed financing.

Citrini argues that this type of lending "is a drag—costs outweigh benefits and are constrained by the size limitations of large banks." Once regulatory rules change, the bank could "abandon this type of lending and return to a growth trajectory," thereby narrowing its valuation discount compared to its peers.

Bullish in the medium term, but long-term concerns remain.

It's worth noting that Citrini's optimistic assessment of long-term US Treasury bonds has a clear time horizon. The institution expects the window for narrowing yield spreads to be concentrated in the next three months, around the time of the Treasury's refinancing announcement on November 4th.

However, looking further into the long term, Citrini maintains a bearish stance on long-term US Treasuries. His reasoning is that Bessant's strategy of maintaining nominal economic growth above government borrowing costs will cause bondholders' real returns to lag behind inflation. Furthermore, declining yields could stimulate more borrowing, further exacerbating inflationary pressures.

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