January: One Down, Eleven to Go

Being Kevin Warsh

Soundbite: Kevin Warsh is the chosen one. Now begins the avalanche of conjecture about the degree to which he can effect change at the Fed, which he has wanted since 2009. We think the more important discussion is his potential clash with investors over 1) his argument that increases in the money supply are inflationary and 2) his determination to cut the Fed’s balance sheet. We question Warsh’s ability to balance two opposing policies by cutting interest rates quickly as he simultaneously reduces the balance sheet.

Warsh’s track record at the Fed has attracted attention. We are open to the possibility he realizes his mistake when he was worried, even into Lehman’s 2008 bankruptcy, that monetary policy could stir inflation. However, he seems to continue to stick to the same belief system based on comments made in an April 2025 speech titled “Commanding Heights: Central Banks at a Crossroads.” His views on shrinking the Fed through contracting not just the scope of its communication, but its balance sheet, could lead to problems during an economic slowdown. Assuming Warsh refuses to deliver the QE punchbowl when business conditions deteriorate, it will put him at odds with investors. We foresee a situation where the market could become an unstoppable force by selling stocks to press the Fed to adopt QE when demand slows. If Warsh becomes an immovable object, then we are in for trouble.

Our new Fed Chair is skeptical of the central bank’s strong attachment to backward-looking economic data, and FOMC voters who get trapped by their public economic projections. This could result in a much less visible and predictable monetary policy path that will raise fixed income volatility and lower stock valuations.

As long as the economy does not encroach upon either of the Fed’s dual mandates, everything will be fine. However, that is not the way the world works, and we can expect conflicts.

Regarding Price Stability Mandate:

Yes, Kevin Warsh did have an inflation fixation during 2008, and yes, he may have learned the error of his ways. The problem is, his process has not changed, and that means there is a policy mistake waiting to happen if the economy slows while money supply is rising. Money supply was already growing at a healthy 5.7% annual rate when the country entered recession in December 2007, and it rose to a frothy 10.2% during the crisis. Such rapid growth in the money stock reminded Warsh of the inflationary 1970s. However, had the FOMC member focused on the “outdated economic data” (one of his criticisms of the Powell Fed), and not on money supply, he would have made better decisions.

Regarding Maximum Employment Mandate:

The upcoming Chair will upset investors who have become conditioned to Fed liquidity injections when he attempts to reduce the balance sheet, even if he does so as he cuts rates. Warsh will be extremely reluctant to expand the Fed's balance sheet in the event of a recession, especially if he has not trimmed it down enough beforehand. If he does taper the Fed’s balance sheet assets when he assumes the helm, that tapering could contribute to slower growth; during which he will focus solely on rate policy, not QE. This is a man who strongly believes in a “narrow central bank” but investors like the largesse.

Regarding rate hike potential under a Warsh Fed:

Note that last year he said: “We should remember that the revealed preference of the body politic is a deep distaste for inflation—and also, for bailouts.” This heightened sensitivity to inflation could put him in conflict with the rest of the Federal Open Market Committee, the administration, and investors.

Regarding future rate cuts, we need to break it down into two paths:

• The first is if the economy heads toward recession. Under this scenario, a real Warsh problem arises thanks to his view that QE is backdoor fiscal policy. From his 2025 speech:

“Each time the Fed jumps into action, the more it expands its size and scope, encroaching further on other macroeconomic domains. More debt is accumulated…more capital is misallocated…more institutional lines are crossed…risks of future shocks are magnified…and the Fed is compelled to act even more aggressively the next time."

He believes the Fed’s use of QE not only blurs the lines between fiscal and monetary policy but promotes fiscal liberalism from a U.S. Congress that "found it considerably easier appropriating money knowing that the government’s financing costs would be subsidized by the central bank.”

Therefore, in the first case of an economic slowdown that pushes the Fed to cut, there will only be rate cuts and no balance sheet expansion, but with three-quarters of the FOMC estimating the neutral rate sits at 3% or higher, relying just on rate cuts may be too limiting.

• In the second case, where rates are cut not to avoid a recession but to offset balance-sheet reduction under Warsh, it’s important to remember that over half of the $6.6 trillion Fed balance sheet is comprised of Currency and Treasury General Account liabilities that the Fed cannot control. Therefore, further asset reductions will be limited to the other half of the Fed’s liabilities, which consists of bank reserves. The $3 trillion in reserves is a short-maturity liability that pays interest, which is motivation for the Fed to shorten the duration of their portfolio; but to think Warsh will be able to affect significant reductions is unrealistic. Cutting reserves too deeply will create liquidity dislocations throughout the banking system. It is for this reason that he will need to move slowly because repo rate market tightness will curb his ability to quickly cut the balance sheet.

Bottom line: without quick balance sheet cuts that Warsh stated are a prerequisite for rate cuts, do not expect quick drops in short-term yields.

Regarding more limited Fed communication in a Warsh-led Fed:

While we hope he will not ban the Summary of Economic Projections, his 2025 speech disclosed:

“Once policymakers reveal their economic forecast, they can become prisoners of their own words…Forward-guidance…has little role to play in normal times.”

We expect that despite the concerns surrounding his appointment, the central bank’s institutional foundation will be preserved by its existing members. They will guarantee the bank retains not only independence, but integrity and legitimacy. Therefore, we are not worried about Warsh at the outset of his term, but we are nervous about markets testing his resolve as Chair when the economy hits a rough patch. Volatility always rises into market downturns, but the degree of volatility could reach larger ranges under this Fed Chair than it would under different leadership.

Bessent & Bowman: Conspiracy Theories

Soundbite: Treasury Secretary Scott Bessent is rolling out the administration’s goal of building Parallel Prosperity for Wall Street and Main Street. A major part of that platform is deregulation to remove “barriers to innovation” for financial institutions in the form of “enhanced supervisory and regulatory frameworks.” To us, “enhanced” means vastly reduced rules. When we became aware of the steps the Treasury Secretary is taking to loosen regulations, there were obvious parallels to Michelle Bowman’s action last November for reduced oversight at the Fed. It makes us wonder if there is coordination between the Fed and Treasury. Using similar language to Bowman’s revised regulatory and supervision framework to supervise banks, the Financial Stability Oversight Council (FSOC) and Bessent are moving to “remove impediments to economic growth” by limiting their efforts to “material financial risks.”

The result of these actions will dilute regulatory oversight and, as we wrote in November, “could lead financial institutions to lower lending standards without fear of Fed oversight.” With Bessent also directing independent bank regulatory agencies to move in lockstep, mandating that regulators ease up on supervision moves them from monitoring risks to bolstering economic growth. This can be positive for lending, the economy, and markets; that is, until loan defaults rise.

We wrote about Bowman’s move to cut bank red tape (and cutting Washington staff 30%) two months ago. This marked a fundamental change in how the central bank will respond to risks, and now the Treasury is closing that circle with a regulatory reset. Both Bowman and Bessent are focusing only on “material financial risk” in determining a lender’s safety and soundness, while ignoring emerging risks. In our point, Michele Bowman, Vice Chair of Undersight, we wrote, “handcuffing supervisors makes them less able to flag potential crises just as we enter a period when the chance of adverse events is rising.” Now fold in Secretary Bessent’s agenda which includes strong coordination across other regulators, and we find ourselves in a world with fewer critical checks on bank lending practices.

The positive spin is that removing regulatory burdens will make for a more efficient and more profitable banking system. The downside is that accommodative regulatory agencies shirk their risk management duties to generate more borrowing by adopting less sound underwriting and due diligence practices. This leads to higher-risk loans as leverage mounts in the system. Again, good on the way up, but guiding federal regulators to ignore potential risks until they become material goes against the spirit of prudent regulation.

Regulators adopting a growth mindset. What could go wrong?

We turn to Michael Barr, whom Bowman succeeded, for the final word. He remarked  that “this new direction creates a ‘dangerous environment’ not only for the banks but for the economy.”

Sahm Rule ‘Rithmatic

Soundbite: The Bureau of Labor Statistics (BLS) should finally be back on track starting with this Friday’s Nonfarm Payroll report. Due to a stagnant labor pool, we believe that if the unemployment rate moves up this year, the Sahm Rule recession indicator can help time a cycle slowdown. The Sahm Rule smooths the unemployment rate over three months and selects the lowest level from the last twelve months. That base must then be exceeded by the most recent three-month average by half a percent. When that happened in the past, it was an accurate indicator to begin to ease monetary policy to counteract recessionary forces. If the Fed is right that employment is stable, then the Sahm Rule will continue to be neutral, and stocks can continue to rise. However, the indicator is two-thirds of the way to signaling a recession; consequently, if unemployment rises, then there will be more than a little turbulence ahead.

We prefer to cut through the chaotic nature of news flow and market action and rely on the robust simplicity of the Sahm rule to assess economic strength. If the average of the February, March, and April payroll reports is above 4.7%, the Sahm Rule suggests there is a very good chance the economy is entering a recession. The average of the last three unemployment readings is already 1% higher than the April 2023 low of 3.4%. If this steady uptrend continues, it can develop into a major problem.

Because unemployment has been rising, we were puzzled that last week’s FOMC statement took out wording about the downside risks to employment. However, if the Fed is correct that employment is stable, the Sahm Rule will lower its recession odds and be in alignment with the current bullish consensus.

The Sahm Rule was triggered in July and August of 2024 without a subsequent recession. We have written that the bad signal can be explained by the years of accumulated stimulus of a bloated Fed balance sheet and pandemic checks. More specifically, it was that the unemployment rate was increased by high immigration driving up the labor supply. Therefore, the Sahm Rule was biased higher by an increase in supply, not a drop in demand. Declining labor demand is what normally drives the Sahm calculation higher, and that is what leads to the slowdown.

Given vastly reduced immigration flows under the current administration, the conditions for a valid Sahm Rule warning are in place on higher unemployment.

For the upcoming January unemployment rate, the Sahm Rule goes into recession territory on Friday with a 4.9% print, too far above trend to be relevant. The same is true for February. However, the April threshold is 4.7%, and if there is a slow increase of 0.1% per month starting with Friday’s data, that will be a set up to arrive at a 4.7% three-month average in April, triggering a recession warning.

One can argue that a lot can happen between now and April that could stave off a recession even with a move to 4.7% unemployment, but the market is a discounting mechanism, and if the job market continues its steady deterioration, investors will begin to anticipate that the 4.7% threshold will be reached. That means before April, stock valuations are vulnerable to downdrafts. This makes the Household Survey’s unemployment data a significant market driver once again.

What to Look for This Week

(All times E.S.T.)

1. Friday, February 5 at 8:30 a.m. The Employment Jubilee for January. Now that the government’s Bureau of Labor Statistics has returned to its normal cadence, I will be focused on the unemployment rate. This week we also have JOLTS data for December on Tuesday, February 3 at 10:00 a.m. and we are looking to see if the Quits rate spike in November was due to bad data. ADP Employment Change data is out Wednesday, February 4 at 8:15 a.m. That series has flipped sign almost monthly since Q2 2025, and it was up in December. Thursday, February 5 at 7:30 a.m. Challenger Job Cuts Report for January.

2. Wednesday, February 4 at 10:00 a.m. ISM Services PMI for January. Specific focus on the Prices Paid subcomponent which can lead CPI. Prices Paid had risen for 18 months before falling strongly in November and December, from 70 to 64. If purchasing managers in the service sector see renewed pricing power, it could feed into higher CPI and PCE statistics. ISM Manufacturing Prices Paid data have been up slightly in November and December and will be updated on Monday, February 2.

3. Thursday, February 5 at 8:30 a.m. Initial and Continuing Claims. The initial claims data are noisy, so most economists prefer the 4-week moving average, and that smoothed data has fallen from 240,000 in September down to 205,000. Since December 2021, the data has been contained between 200,000 and 250,000. It dipped below 200,000 for just a single week over the last four years, so any further drop would justify the FOMC believing the labor drop has stabilized.

Monday, February 2 at 3:00 p.m. The Treasury Department revised forecasts for Q1 and preliminary Q2 2026 borrowing estimates. The Treasury Quarterly Refunding Announcement comes out Wednesday, February 4 at 8:30 a.m.

FOMC Voters Speaking: Fed Governor Lisa Cook is back from the Supreme Court hearings and speaks Wednesday, February 4 at 6:30 p.m. Outgoing Atlanta Fed President Emmanual Bostic speaks on Monday, February 2 at 12:30 p.m., and Thursday, February 5 at 10:50 a.m. We will be looking for comments regarding any new direction the FOMC may take. Tuesday, February 3 at 9:40 a.m. Vice Chair Michelle Bowman speaks, and it could be a highlight for the week. Friday, February 6 at noon, Fed Governor Phillip Jefferson speaks. Additionally, Monday, February 2 at 2:00 p.m. the quarterly Fed Senior Loan Officer Opinion (SLOOS) Report is out and at 10:30 p.m. on Monday, the Royal Bank of Australia is expected to raise rates by 25 basis points after cutting three times last year. Thursday, February 5 at 7:00 a.m. the BoE rate decision is announced, and the ECB decision is at 8:15 a.m. Neither are expected to lower rates. Later, Thursday at 2:00 p.m. Banco de Mexico rate decision; it has cut almost every meeting since March 2024, dropping its benchmark rate from 11.25% to 7.0%.

Earnings: Palantir Technology (PLTR) starts the week with results after market on Monday, February 2. PLTR has fallen 25% in six weeks, so we will watch the price action to determine the tone after the news. Tuesday, February 3 after market, Advanced Micro Devices (AMD) announces earnings after market. Wednesday, February 4 after market, Alphabet (GOOG) releases Q4 earnings; the stock has been the best performer among its Magnificent siblings, boosted in large part thanks to its TPU architecture. Amazon (AMZN) follows on Thursday, February 5 after market.

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By Peter Corey

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