New head of the Federal Reserve's ultimate challenge: a "balance sheet bomb" of $6.6 trillion and a direct clash with the White House's rate cut orders.

As investors await President Trump's nomination for the next Federal Reserve Chairman, a key question arises on how the candidate will manage the central bank's balance sheet, which stands at a whopping $6.6 trillion. The focus has largely been on whether Trump's choice will significantly lower borrowing costs, as the President has been pressuring current Chairman Powell for months. However, another major issue is whether the Fed should continue purchasing Treasury bonds to maintain its current balance sheet size, or attempt to withdraw more liquidity from the financial system. This decision will directly impact key markets, which are core sites for daily interbank lending among the world's largest financial institutions. Former Fed governor Kevin Warsh is seen as the leading candidate for Trump's nomination announcement next week, and he has been critical of the central bank's current strategy. "Warsh's key distinction is that he strongly advocates for the Fed to maintain a smaller balance sheet," said Angelo Manolatos, strategist at Furukawa Bank. "However, achieving this goal is particularly complex, as the Fed ceased shrinking its balance sheet in December and is currently expanding its balance sheet size." In his numerous speeches over the past year, Warsh has argued that the Fed's aggressive bond-buying programs in recent years have gone too far and may lead the Fed into "fiscal policy's messy political quagmire." Other candidates have taken a more moderate stance on the balance sheet. BlackRock executive Rick Rieder has said the Fed should stop shrinking its holdings to avoid disrupting market stability. Current Fed governor Christopher Waller has also supported halting portfolio reduction. National Economic Council director Kevin Hassett's comments on monetary policy have focused more on interest rates than asset holdings. The next chairman will need to navigate the currency market, which has proved to be highly sensitive to even the slightest changes in reserve conditions. 2019 serves as a typical example when the Fed had to intervene to ease funding pressures. Subsequently, at the end of last year, volatility in funding markets spiked, raising repo rates and increasing demand for the Fed's overnight repo facility. Government borrowing increased, and the Fed's reduction in asset holdings (quantitative tightening) has drained cash from the money market. The Fed later supplemented reserves to the financial system through bond purchases. The Fed began buying around $40 billion in short-term treasuries per month last month to ease upward pressure on short-term rates. However, market volatility towards the end of 2025 underscored the disagreement on how much the Fed can reduce its asset holdings without causing instability. "What is the primary policy tool?" asked Priya Misra, portfolio manager at JPMorgan Asset Management. "Is it the federal fund rate, and is the balance sheet just a secondary tool? This is still a fundamental question. Can the new Fed chairman convince everyone to change their views after taking office?" Warsh has been critical of the Fed's more aggressive use of the balance sheet for over 15 years. He initially supported the bond-buying program after the 2008 global financial crisis, but later warned that restarting purchases could trigger inflation and distort market signals. Broadly, Warsh believes that by artificially lowering rates for a long time, the Fed has fueled the accumulation of U.S. government debt and encouraged a situation he calls "monetary dominance," where financial markets overly rely on central bank support. In contrast, Rieder said in an interview in June that the Fed should end portfolio reduction to avoid excessive liquidity tightening and disrupt market stability. Meanwhile, Waller previously supported maintaining a smaller balance sheet, but changed his stance after tension arose in the money market. Betting heats up After Trump hesitated last week on nominating Hassett as Fed chairman, online prediction market odds showed a significant rise in Warsh's chances of being nominated. Recent comments from Trump regarding Kevin Hassett, director of the National Economic Council (previously seen as the fourth contender), have caused Warsh's odds of getting the position to soar in online prediction markets. "In addition to interest rate policy, the next Fed chairman's view on the balance sheet is crucial. Ultimately, balance sheet policy, like interest rates, is determined by the committee," said Genadi Goldberg, head of U.S. interest rate strategy at TD Securities. Goldberg added that Warsh's stance on the balance sheet may instinctively clash with political considerations at the White House. "The administration is pushing hard for rate cuts, so either a hawkish interest rate view or a balance sheet view won't be welcomed in that context." Whoever succeeds Powell will face pressure from the White House to significantly lower rates, even as bond markets become increasingly sensitive to fiscal risks and liquidity conditions. "This issue is coming to the forefront," Misra said. "The bond vigilantes are waking up, and the government is also realizing the importance of fiscal issues. If we see both fiscal easing and bond vigilantes pushing back, the Fed will be caught in the middle."