The Taiwan Banker

During the Great Recession, in the scramble for safe assets, bond markets went long-duration. Governments saw the opportunity to secure long-term funding, while central banks (led by the US) bought up this debt precisely to push investors away from these safe assets. The inflationary turn since the pandemic has prompted a messy repositioning by all parties. Recent actions by Treasury Secretary Scott Bessent are part of that process, gradually adjusting the government’s credit portfolio toward the shorter end. In late July, the US intervened in the yen market, aiming to contain bond yields as Japan sought access to its US assets in the wake of currency depreciation caused by inflationary headwinds. Subsequently, he also expanded a buyback program for long-term debt, implicitly funded by issuing shorter-term debt. Bessent has called this scheme a reverse version of Operation Twist, the name of a 2011 scheme by the Fed to increase the duration of its balance sheet without affecting its overall size – a “Treasury Twist.” Bessent has also spoken about optimizing management of the Treasury General Account, the government’s liquid bank account, to more sustainably fund such operations. On the central bank side, these actions coincide with the end of quantitative tightening and accelerating growth of the balance sheet (Fig. 1). While passive in nature, this growth has the appearance of quantitative easing in an inflationary environment, which would be an important signal of fiscal dominance, i.e. loss of central bank independence. Central bank assets are likely to emerge as a central element of American fiscal sustainability. The outspoken, yet contradictory statements by Fed officials on the topic give an impression of an active negotiation. First, in September 2025, the Trump-appointed Governor Stephen Miran asserted the validity of a historical third mandate for the Fed to keep long-term borrowing costs down, besides just steady prices and low unemployment. This would imply a flatter yield curve, allowing higher short-term rates to coincide with a larger balance sheet on the long end. (Miran no longer serves in the Fed.) During his April confirmation hearing, however, now-Chair Warsh called for the Fed to gradually reduce its balance sheet, which would imply less attention to long-end yields. “Fed independence is placed at greatest risk when it strays into fiscal and social policies where it has neither authority nor expertise,” he said. He has also cited rising long-term bond yields in the open market as doing disinflationary work, although later clarifying the short-term interest rates remain the primary tool of monetary policy. These statements, confusing at best, underscore that the Fed genuinely lacks good options. Even though in theory, as an issuer of fiat currency, it cannot go bankrupt, in reality, it has been caught out by the same forces affecting the rest of the market – specifically, tightening duration. While the assets it continuously holds do not interact with the markets, once it considers how to shrink its balance sheets, their composition becomes more relevant. Stepping back, there are a number of ways to understand the debt situation of the US. One can look at pricing statistics: the nominal yield on 10-year Treasury bonds has increased to 4.8%, or the 30-year to 5.2%. Quantity-based measures provide another perspective: relative to GDP, total publicly held debt is 123%, while the 2026 projected federal deficit is 5.8%. Duration is however more specific to bond markets; it can reflect structural changes affecting solvency. The weighted average maturity (WAM) of outstanding debt has decreased from 6.3 years in the post-pandemic peak to 5.8 years now as the Treasury aims to avoid locking in higher rates. Besides the government, this change affects players including deposit-taking banks, foreign holders such as Japan, and even the Fed itself, all in parallel ways which are a little more subtle than just pricing effects. Any buyer holding long-term debt over the past five years has already lost money if they have been required to recognize the new valuation, constraining their liquidity. This was the phenomenon which precipitated solvency concerns for Silicon Valley Bank in 2023, ultimately leading to its collapse. While not understood to be systemic at the time, the consequences of that continue to reverberate, dissuading the Fed from getting too aggressive on its reserves policy, which would be required to shrink its balance sheet. The duration crunch is also forward-looking, as inflationary drivers are not expected to subside in the near future. Part of the reason the market can no longer bear longer-term commitments is that the composition of the buyers has moved marginally from official reserves into private-sector holders like hedge funds, who tend to be leveraged and more rate sensitive. With the Treasury borrowing now increasingly concentrated in the short term, meanwhile, any increase in interest rates has an immediate effect on interest outlays and fiscal health. These forces all coincide to put the Fed in a complex and sensitive position on balance sheet policy. To reduce its balance sheet in an active fashion, it would need to sell its disproportionately long portfolio into an increasingly thin market which is already showing signs of distress, putting Warsh on a collision course with Bessent. Passively rotating its portfolio to better reflect the open market, on the other hand, would take longer than the pace of monetary policy, considering that expiring debt is disproportionately short-term. It is worth noting one significant exception to the market’s declining demand for long-term debt, which is corporate borrowing related to AI. The burgeoning growth of this sector provides reason for optimism about the economy, while also sucking capital out of government debt to some extent. Warsh’s Jackson Hole speech in late August made special mention of AI as a potential productivity driver; optimistically speaking, it could provide tax revenue to aid with the country’s fiscal situation. A glance at the Fed’s balance sheet however points to another sector which might have disproportionate influence on monetary policy: housing. Besides government bonds, much of the Fed’s holdings are made up of mortgage-backed securities. If long-term yields spiked more than they have, the most immediate tangible impact would come from ownership costs for new homebuyers. Housing policy has been gradually emerging as a federal-level political issue over the past few years. The 21st Century ROAD to Housing Act, which became law on July 11, is the most significant federal housing legislation in decades, and Congress’s main legislative achievement during Trump’s second administration. In the American system, most mortgages are fixed-rate, which has several implications. When rates fall, borrowers pre-pay their loans and refinance. When they rise, on the other hand, holders tend to be stuck with their depreciating assets, which creates an asymmetric duration profile. In the real economy, meanwhile, borrowers lose geographic mobility, being tied to specific properties unless they are willing pay large rate penalties from newly issued loans. The productivity effect Warsh has emphasized from AI is unproven, but the same effect is very much active for real estate, and in the wrong direction. In time, it will contribute to inflation, but a lack of construction takes time to show up in price statistics. To be blunt, Warsh’s hopes for less politicized bond markets are moot, even if one were to sympathize with the difficulty of his task. That is where the full brunt of the supply-constrained economy will first show up in a politically legible form. A committee will deliver recommendations on the balance sheet to the Federal Open Market Commission in December, an institutional form which can help insulate the Chair from some of the fallout. The results will nevertheless have deep implications for the independence of the central bank.