How We View the “Warsh Turbulence”?

Summary:

• US President Trump has officially nominated Kevin Warsh, exacerbating market concerns and asset price volatility in overseas markets amid already tight liquidity conditions.

• Markets are focusing on some of Warsh’s past proposals, including accelerating interest rate cuts while restarting quantitative tightening (QT), and addressing liquidity issues by easing bank regulations. We believe this idea lacks practical feasibility. Compared with 20 years ago, the primary purpose of the Fed’s balance sheet expansion has shifted from market rescue to providing liquidity for financing needs such as Treasury bonds. Therefore, against the backdrop of uncurbed fiscal deficits, sustaining QT would be challenging for the Fed. Meanwhile, massive investments in AI have driven a surge in demand for debt financing, further tightening liquidity in credit and bond markets and potentially spilling over into other asset markets. This forced the Fed to restart balance sheet expansion in December, making another round of QT highly risky.

• Judging from the changes in US commercial banks’ leverage ratios over the past 20 years, if the Fed implements QT and eases regulations—effectively reverting to the endogenous money model—it could instead lead to outcomes that are unacceptable for policymakers, such as a sharp deterioration in liquidity and a collapse in asset prices. Therefore, we believe easing bank regulations cannot serve as a sufficient condition to offset the impact of QT.

• We maintain our overall view of a slow bull market in A-shares. The rapid bullish sentiment in early January has been successfully moderated, which should make the future trajectory of A-shares more stable. We still forecast the full-year increase of the A-share main index in 2026 to be in the range of 10%–15% and thus remain positive on A-shares at current levels.

• Market concerns over large-scale capital expenditures and debt issuance by US tech stocks have intensified, alongside uncertainty over whether Kevin Warsh might adopt a hawkish stance by pursuing QT. Although we believe that probability is very low, it is true that the US equity market and the US credit and bond markets are facing pressure from tightening liquidity. Therefore, we hold a relatively neutral view on US stocks.

• Gold and base-metals had risen too quickly earlier, attracting large amounts of speculative leveraged fund inflows. As a result, gold and base metals will likely consolidate below their recent highs in the short term. We remain positive in the medium term on gold and copper, which are supported by real demand. However, we maintain a neutral view on other commodities that have rallied alongside with the trend, as we do not expect the global economy in 2026 will provide a solid foundation for broad-based inflation in commodity prices.

Previous Views:

We believe that the overall macroeconomic policy will remain accommodative in 2026. The major US stock indices are still expected to rise, but performance is likely to become more divergent across individual stocks. We maintain our view that the A-share market will stay on a slow bull trajectory. Investors should avoid buying gains and selling losses. On the contrary, if equity indices correct consecutively, it will present a good opportunity to build long positions for the 2026 market. If indices rise rapidly, investors do not need to chase highs, instead can wait for a pullback before entering. We continue to be optimistic about gold and base metals.

Views in February:

I. The “Warsh Turbulence” Will Only Have a Temporary Impact on the Market

On January 30, US President Donald Trump formally nominated Kevin Warsh as the next Chair of the Fed, to succeed Jerome Powell, whose term expires in this May. The nomination will not take effect until it is reviewed and confirmed by the Senate Banking Committee. Warsh’s nomination came as a surprise to the market, given that he was not regarded as the most likely candidate for the next Fed Chair until one week before the nomination. As an unexpected event, his nomination has inevitably led to corresponding volatilities in market expectations. In the short term, this has triggered a rebound in the US dollar, declines in precious metals and digital currencies, a pullback in US equities, and a renewed steepening of the US Treasury yield curve.

We believe the main reasons for Warsh’s nomination are that his two key policy positions—accelerating the pace of interest rate cuts and pushing US bank deregulations—are fully aligned with Trump’s views. . In addition, compared with other candidates, Warsh, who was previously regarded by the market as belonging to the hawk’s camp, may be relatively more effective, at least in the short term, to ease concerns over the Fed independence and stabilizing inflation expectations.

However, the market is paying closer attention to some of Warsh’s past views, including accelerating interest rate cuts alongside having the Fed resume quantitative tightening (QT) to reduce its influence on financial markets, and addressing liquidity issues by pushing bank deregulations.

In our view, this idea lacks practical feasibility under current conditions. First, unlike the Fed’s balance sheet expansion during the Bernanke era after the 2008 financial crisis, the Fed’s asset purchases now are increasingly focused on US Treasury securities, rather than providing liquidity support to financial institutions or other specific financial products such as MBS. The change comes as the U.S. fiscal deficit has steadily expanded since the COVID-19 pandemic, rising from approximately 4% of GDP per year to nearly 7% at present. As a result, the primary purpose of the Fed’s current balance sheet expansion is to act as a buyer in the Treasury market. Therefore, to pivot back to quantitative tightening and shrink the balance sheet to its previous size, the foremost requirement is a substantial reduction in the US fiscal deficit. However, following Trump taking office last year, deficit-reduction measures spearheaded by Elon Musk’s Department of Government Efficiency (DOGE) were never fully implemented. Under mounting pressure from various sides, Elon quickly resigned from the U.S. government, and the DOGE he founded was disbanded. Consequently, the US fiscal deficit did not see a meaningful reduction in 2025 (Figure 1). This year, the Trump administration faces pressure from the midterm elections. Meanwhile, its previously proposed plan to drastically cut healthcare spending has encountered strong opposition from congressional Democrats. To avoid another government shutdown, Trump has already compromised with Democrats on healthcare issues. We therefore conclude that a significant decline in the US fiscal deficit remains unlikely in 2026; in fact, the probability of a further increase is even higher.

Second, without a meaningful reduction in the fiscal deficit, the impact of Fed’s interest rate cuts on the market is compromised. This is because the federal funds market, which is directly affected by the federal funds rate, is now too small relative to the continuously expanding size of the overall US financial and bond markets. For instance, the outstanding volume of US Treasury securities traded in the open market now stands at $31 trillion, while the total equity market capitalization at $65 trillion, and the credit bond market at approximately $11 trillion. If the Fed were to pursue further QT while cutting rates, its policy rate would only affect the fed funds market, where daily trading volume is roughly $100 billion. It would not even fully transmit to the Interbank Secured Overnight Financing Rate (SOFR) and the short-term Treasury bill market. As an illustration, before the Fed launched its RMPs to expand its balance sheet by purchasing more T-bills last December, the spread between SOFR and the federal funds rate remained at an abnormal level above 20 basis points. The Fed’s balance sheet expansion helps to reduce that spread (Figure 2). Nevertheless, long-term US Treasury yields have still not declined.

Trump has repeatedly criticized incumbent Fed Chair Jerome Powell for cutting interest rates too slowly, and his decision to nominate Kevin Warsh to replace Powell is mainly driven by Warsh’s stance favoring faster monetary easing. However, Warsh’s past proposal of combining rate cuts with QT will almost certainly struggle to win Trump’s support and approval going forward. Under a Fed QT scenario, as market conditions over the past six months have demonstrated, even the short-term risk-free SOFR cannot be guaranteed to fall in lockstep with Fed rate cuts—let alone medium- and long-term bond yields and rates on other debt instruments carrying credit risk. Beyond the heavy Treasury issuance pressure stemming from large fiscal deficits, another critical factor tightening financial conditions has been the surge in AI-related capital expenditures by US Tech firms, particularly since the second half of last year. This has led a growing number of US tech firms to turn to debt financing to fund their operations. Take the Magnificent 7 (Mag‑7), the most prominent US tech giants, as an example: their demand for debt financing has risen sharply amid mounting AI‑related capital spending.

According to their published annual reports, the Mag‑7’s net debt financing soared to $51.2 billion in Q4 of last year. Previously, these companies barely needed to rely on debt financing due to their robust profitability and operating cash flow. However, the AI competition is far from over, and these tech giants have all signaled plans to commit even larger capital expenditures to the race. This will inevitably intensify overall credit market demand for funds and supply of debt. Against this backdrop, if the Fed does more QT, it will exacerbate supply‑demand imbalances across the US dollar debt market and lead to a further tightening of liquidity.

Conditions in the debt and credit markets are crucial not only for future AI investment but also for the performance of the U.S. stock market. On one hand, AI‑related tech stocks represent the largest and most closely watched segment of the US stock market; significant risks in this sector would inevitably trigger a broad‑based decline in US equities. Indeed, since Q4 2025, concerns about over-expansion in AI investment—leading to deteriorating cash flow metrics at these tech giants—have already exerted substantial downward pressure on some of their share prices. On the other hand, liquidity strains in US credit and bond markets will ultimately spill over into the equity market. Currently, US stock valuations remain significantly above historical averages, with investor leverage high and cash ratios close to record slows. A decline in equity market liquidity would therefore almost certainly lead to stock market declines. In this context, an accelerated Fed QT would likely amplify liquidity tightening effects, potentially triggering panic‑driven sell‑offs across broader markets, including equities. On the basis, we assess that the probability of incoming Fed Chair Warsh restarting QT upon taking office is very low.

Furthermore, compared with Jerome Powell, Warsh’s Fed leadership would inevitably entail a reduction in central bank independence. First, after resigning from the Fed in 2011 as he was against quantitative easing, Warsh has been a vocal critic of Fed policy, leaving him with relatively cold relations with the traditional Fed establishment. Second, Trump’s nominee, Warsh, is unlikely to receive support from congressional Democrats. To establish his position at the Fed, Warsh will rely heavily on backing from Trump’s faction than Powell has. As result, he cannot possess full independence from President Trump.

Over the next four‑month transition period until Warsh assumes office, markets will first speculate on his future policy path based on his past statements, which is likely to increase market volatility. Once initial uncertainty abates, we expect markets to gradually revert to fundamental logic. In particular, after navigating last year’s volatility and turnarounds—including the trade war, Elon’s DOGE drama, and Trump’s TACO—markets have become less prone to fear‑driven reactions to rhetoric‑based policy signals. We therefore conclude that while Warsh’s nomination will generate volatility, both the magnitude and duration of such swings should be significantly smaller than those triggered by last year’s Trump tariff trade war and Elon’s DOGE drama.

II. Can Us Bank Industry Deregulation Fully Offset the Impact of Fed’s Qt?

Another key assumption underlying Warsh’s “rate cuts + QT” combination is his belief that easing regulatory requirements on US commercial banks and encouraging them to increase leverage would offset the liquidity shocks caused by Fed’s QT. We argue that this is highly unlikely to be achievable in practice.

The logic of bank leverage expansion driven by deregulation rests on the “Endogenous Money Theory”—the idea that money supply is determined by credit demand within the economy and banks’ lending behavior, with the central bank playing only a passive accommodating role. This is a neo-Keynesian monetary theory, yet it has encountered mounting problems in global monetary policy practice over the past two decades.

First, endogenous money is inherently procyclical: credit demand and bank lending tend to strengthen during economic expansions and weaker during downturns. When this procyclicality exceeds the influence of conventional monetary policy tools (rate hikes/cuts), macroeconomic policy becomes ineffective. This leaves governments and central banks unable to address extraordinary economic challenges, such as financial crises or large-scale pandemics. In practice, over the past 30 years—from Japan to Europe, the US, and China—the phenomenon of exogenous money has become increasingly dominant: money supply is exogenously determined by central banks, independent of economic activity. While this shift has enhanced policymakers’ ability to respond to crises, it has also drawn criticism from traditional economic theorists and fueled market concerns about persistent high inflation and eroding monetary credibility.

We believe that such market concerns about inflation and monetary credibility are reasonable. However, abandoning the current exogenous money framework and reverting to the endogenous money regime of 20 years ago is unrealistic. First, there is no evidence that inflation in major economies has been significantly higher during the past 20 years of exogenous money dominance than during the earlier endogenous money era. This is because, despite faster money and debt growth, sustained improvements in global productivity and expanded production capacity from globalization—especially the massive manufacturing output boost after China’s WTO accession—have kept global inflation low, creating more policy space for exogenous money management. While the surge in gold prices in recent years may reflect worries about monetary credibility, claims that exogenous money is unsustainable still lack sufficient empirical economic support.

Second, looking at the specific situation of US commercial banks, we argue that even under a deregulation, they will not return to the leverage levels seen prior to the 2008 financial crisis. Bank leverage ratios—measured as total assets divided by total net worth—indicate that a higher multiple corresponds to greater leverage. As shown in Figure 4, US bank leverage fell sharply after the 2008 crisis. This cannot be attributed solely to tighter regulation. In our view, a more important factor is the fundamental shift in banks’ business models and risk appetite post-crisis. The 2008 crisis led to the failure of several major US banks; for other surviving banks, shareholder equity was severely diluted by plummeting stock prices and government capital injections. Since then, private shareholders of US banks have favored stable, lower-leverage business models, rejecting the high-risk, highly leveraged approach that relied on aggressive balance-sheet expansion before the crisis. Even if regulatory constraints are relaxed, US commercial banks —being privately owned—are unlikely to revert to pre-crisis leverage levels, as private shareholder preferences are the core constraint on their risk-taking and leverage decisions. Indeed, during his first term, Trump repeatedly eased bank regulations: the Volcker Rule was revised three times (2018, 2019, 2020) to loosen restrictions, and the Supplementary Leverage Ratio (SLR) requirement was lowered in Q4 last year. But none of these measures led to any meaningful increase in bank leverage multiples.

Over the decade following the 2008 crisis, the only period that significantly increased the leverage ratios of U.S. commercial banks was the Fed’s QE program implemented after the 2020 pandemic. This pushed the leverage multiple of US commercial banks from below 9 to 11 in 2022 (see Figure 4 above). Afterwards, as the Fed began to QT, the leverage ratio gradually declined again. In our view, this occurred because the Fed’s QE led to a massive increase in reserve levels and cash balances at commercial banks (Figure 5), allowing them significantly more scope to expand their asset size, thereby increasing their asset to equity leverage multiple and vice versa. Therefore, empirical data from 2020 to the present shows a strong positive correlation between the cash reserve levels of US commercial banks (Figure 5) and their asset to equity leverage multiple (Figure 4).

Fed’s balance-sheet reduction will inevitably reduce the total amount of reserves and cash held by US commercial banks. Under such conditions, empirical evidence from recent years shows that commercial banks, on aggregate, tend to lower their asset to equity multiple. If leverage multiples decline while net equity worth growth remains limited, this will necessarily lead to slower growth or even contraction in the total assets of US commercial banks, thereby triggering tightening liquidity in credit and capital markets.

To fundamentally change this dynamic, commercial bank lending behavior would need to shift from procyclical to countercyclical — an outcome that is clearly unachievable under the Western private banking system. In China, it can achieve this because its large commercial banks are state-owned. China’s “exogenous money” framework therefore does not rely on central bank’s balance-sheet expansion; instead, it can use administrative guidance to direct state-owned commercial banks to increase leverage and lend countercyclically. For this reason, China can also be viewed as a country that implements an exogenous money monetary policy regime.

To summarize: we believe the US cannot return to the “endogenous money” framework that existed before the subprime mortgage crisis, nor can major global economies achieve genuine endogenous money today. While exogenous money carries potential risks of persistent inflation and money credibility erosion, these theoretical concerns have not yet materialized into severe real-world problems, given ongoing improvements in global productivity and output. A rapid return to an endogenous money would be not only impractical but also likely to cause a sharp deterioration in liquidity, a collapse in asset prices, and a substantial amplification of procyclical volatility. We conclude that easing bank regulation cannot serve as a sufficient condition to offset the effects of Fed’s QT.

III. “Slow Bull Market” Remains the Main Policy Guidance Direction for A-Share Market

Following the final rally last December, the Chinese A-share market closed near its 2025 peak. This has reignited market optimism. Meanwhile, amid the continuous decline in domestic interest rates, capital previously held in deposits has been shifting into other investment products. Driven by the "early allocation for early returns" mindset, some institutional investors increased their A-share allocations at the start of the new year, leading to a continued rally in A-shares and a sustained expansion in trading volume.

We have previously stated that we remain relatively optimistic about the 2026 A-share outlook. However, we also believe that a "slow bull market" remains the core policy direction guiding Chinese policy makers with respect for the domestic stock market. A too-rapid short-term rally is inconsistent with the "slow bull" policy objective. First, the overall domestic economy has not fully emerged from its downward trajectory. Quarterly economic growth slowed sequentially in 2025, and year-on-year growth in fixed-asset investment has turned negative. Although policymakers expect the "wealth effect" from a rising stock market to boost household consumption and corporate investment, they also want to avoid an excessively fast stock market rally that would divert large amounts of industrial capital from the real economy to the stock market. Second, the lessons from previous bubble-driven bull market in A-shares in 2015 are still fresh. Therefore, the risk of a sharp correction triggered by a runaway bull market and asset bubble boom-bust is a key lesson that the Chinese government will surely heed and try to avoid during the current A-share bull market. Consequently, following the continuous A-share rally at the start of the year, various A-share ETFs experienced large-scale net redemptions for two consecutive weeks from January 13 to 28. The total number of ETFs shares decreased by approximately 120 billion shares (Figure 6), representing a net capital outflow of over 500 billion CNY in two weeks.

In terms of outcome, the rapid rally at the beginning of the year has been contained, and net redemptions of passive equity funds also stopped after the market pulled back. We therefore believe that policymakers’ use of market-based measures to regulate the market – preventing excessively fast gains that could form bubbles and deterring irrational investment behavior such as excessive leverage buying by retail investors – is highly beneficial to the medium- and long-term trend of the A-share market. Large-scale fund redemptions imply more investable capital on the sidelines going forward, which in turn reduces the risk of a significant market decline.

From an investor’s perspective, however, as we recommended in previous reports, investors should avoid excessive “buying gains and selling losses” i.e. refrain from chasing highs when the market rises rapidly, and instead can buy more decisively when the market corrects to a reasonable extent.

IV. Market Strategy

Market concerns over large-scale capital expenditures and debt issuance by US tech stocks have intensified, alongside worries about whether Kevin Warsh will adopt a hawkish stance by pursuing QT once he takes office as Fed Chair. Although we believe the probability that Warsh will turn hawkish and implement QT is very low, the U.S. equity, credit, and bond markets are already experiencing pressure from liquidity tightening. Therefore, we hold a relatively neutral view on US stocks: though major US equity indices are unlikely to fall significantly, their short-term upside room is also quite limited in our view. We would consider buying on dips only if the U.S. market corrects sharply in advance.

We maintain our overall view of a slow bull market in A-shares. The rapid bullish sentiment in early January has been successfully moderated, which should make the future trajectory of A-shares more stable. We still forecast the full-year increase of the A-share main index in 2026 to be in the range of 10%–15% and thus remain positive on A-shares at current levels.

Gold and base-metals had risen too quickly earlier, attracting large amounts of speculative leveraged fund inflows. After the sharp pullback from highs, they need time to digest the previous gains and absorb the speculative fund flows. As a result, gold and base metals will likely consolidate below their recent highs in the short term. However, we remain positive in the medium term on gold and copper, which are supported by real demand and have a relatively low share of short-term speculative leveraged buying. We hold a neutral view on other commodities that rallied along with the trend, as we do not believe the global economy in 2026 will provide a solid foundation for broad-based inflation in commodity prices.