The market is worried about the Fed restarting QT? But the real tool might be SOMA.

Trump’s nomination of Kevin Warsh as the next Federal Reserve Chair has sparked market concerns about the shrinking of the balance sheet. Although Warsh is known for his hawkish stance on the balance sheet, Citi believes the likelihood of a full restart of QT (Quantitative Tightening) is low.

Citi analysts believe the real focus should be on the weighted average maturity (WAM) adjustment of the Fed’s SOMA portfolio—by shifting maturing securities into short-term Treasuries, the Fed can “slim down” the balance sheet without triggering market turmoil. This strategy could release about $420 billion in reinvestment space between the second half of 2026 and 2027. For investors, this suggests a further steepening of the curve, with the 3- to 5-year sector potentially becoming the best “safe haven.”

Warsh’s Hawkish Stance: The Likelihood of “Cutting” the Balance Sheet

As a former Fed governor, Kevin Warsh has always maintained a tough attitude on balance sheet issues.

Last November, he wrote in The Wall Street Journal that the Fed’s balance sheet is “bloated,” and advocated that “it can be substantially reduced. These abundant resources can be redeployed in the form of lower interest rates.”

The market’s immediate reaction was as Citi expected—bull steepening (short end down, long end pressured), with the 30-year swap spread further negative.

Meanwhile, the market has started to price in slight rate hike expectations for 2027/2028, although Citi believes Warsh’s traditional concern for inflation risk is less relevant in the current environment.

SOMA Adjustments: A More Realistic Path Than QT

Citi judges that a full restart of QT will face significant resistance after last year’s repo market volatility. A more likely course of action is:

Reduction of Reserve Management Purchases (RMPs): From the current $40 billion per month down to about $10 billion (Citi expects a natural decline to $20 billion after mid-April). However, this has limited macro impact.

WAM adjustment of the SOMA portfolio: Redirect maturing U.S. Treasuries into short-term Treasuries. Based on a monthly cap of $30 billion, about $140 billion could be achieved in the second half of 2026, and $275 billion in 2027. This approach is expected to receive broad support within the Fed.

Citi points out in its research report that the Fed may increase the proportion of short-term Treasuries in SOMA holdings from the current level to 40%. This adjustment is technically easier to implement and won’t cause the dramatic shocks to reserve levels associated with a full restart of QT.

However, analysts acknowledge that while a full restart of QT is not the base case, it cannot be completely ruled out. This would require the Fed to first improve the settlement mechanism of the Standing Repo Facility (SRP), to dynamically supplement reserves. This would sharply lower the WAM of SOMA and increase the Treasury’s financing needs.

Concerns Over Term Premium May Be Exaggerated

Citi believes that from the Treasury’s perspective, any rolling of SOMA securities increases its financing needs—either issuing more short-term Treasuries or increasing the size of maturities. But if the Treasury continues to favor short-term issuance, the yield curve may not steepen significantly.

Analysts warn that the real risk is another “buyer strike” in Treasuries, which could be triggered by perhaps unwarranted market panic over QT and/or increased auction sizes in the future.

There are currently market concerns about a sharp drop in foreign demand, pushing up the term premium. But Citi data shows that in last year’s 10-year Treasury auction, foreign subscription ratios actually increased.

Normally, the strength of foreign demand in new issue auctions depends on performance in previous reopenings. Recently, the foreign subscription ratio in reopening auctions has been unusually higher than in new issues—this anomaly suggests that foreign demand may remain strong in the next auction (tentatively February 11).

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The above content is from Chasing Wind Trading Desk.

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