The enormous debt weighs on the U.S. government, and Federal Reserve's Logan suggests restarting balance sheet expansion and prioritizing the purchase of short-term U.S. Treasury bonds

According to the Zhitong Finance APP, as the scale of U.S. debt and budget deficits becomes increasingly large, coupled with a new round of trade wars and "de-globalization," major U.S. Treasury bond holders such as China and Japan may significantly reduce their holdings of U.S. debt. The possibility of the Federal Reserve restarting the so-called "balance sheet expansion" process is growing, in order to alleviate the pressure on the U.S. government regarding the repayment of principal and interest on U.S. debt, as well as the overall national debt burden.

It is understood that Lorie Logan, the President of the Dallas Federal Reserve with voting rights on the FOMC monetary policy in 2026, recently proposed a "mid-term policy framework suggestion," advocating that when the Federal Reserve restarts its asset purchase program, i.e., the balance sheet expansion plan, it should prioritize increasing holdings of short-term U.S. Treasury bonds from a mid-term perspective. This would accelerate the dynamic matching of the balance sheet with the issuance structure of U.S. Treasury bonds through optimizing the term structure, which also means that short-term U.S. Treasury bonds are expected to see an accelerated upward trajectory.

Undoubtedly, the Federal Reserve is still in a "balance sheet reduction" cycle, continuously reducing its holdings of U.S. Treasury bonds and mortgage-backed securities (MBS). Therefore, it is very rare for Federal Reserve officials to signal balance sheet expansion during this period. Logan emphasized that when the monetary policy shift requires restarting the balance sheet expansion process, the Federal Reserve's decision-making body should actively increase the allocation of short-term bond portfolios to promote a faster return of the Federal Reserve's balance sheet to a neutral structure.

"Although from a long-term perspective, a balanced allocation of U.S. Treasury asset term structures is needed to more quickly restore the Federal Reserve's holdings of U.S. Treasury bonds to an ideal neutral configuration, over the mid-term, an overweight in short-term bonds will accelerate the neutralization adjustment of the asset portfolio," Logan stated in a speech at a balance sheet policy seminar held in London. This senior official, who previously managed the central bank's asset purchase portfolio at the New York Fed, expressed support for the current ample reserves system of the Federal Reserve and proposed several optimization paths to enhance policy transmission efficiency, ensuring the system operates effectively and efficiently.

U.S. debt interest payments and budget deficits remain high, and the U.S. government seems to be under pressure

Statistics show that the current Federal Reserve's balance sheet of $6.8 trillion includes about $2.2 trillion in agency MBS, but most Federal Reserve policymakers have made it clear that the future asset composition will primarily consist of U.S. Treasury bonds of various maturities. In her latest speech, Logan pointed out: "Matching the duration of assets and liabilities will effectively smooth out fluctuations in the U.S. Treasury bond trading market, thereby strengthening the effectiveness and efficiency of the Federal Reserve's monetary policy communication."

Since the Federal Reserve officially started balance sheet reduction (also known as quantitative tightening, abbreviated as QT) in June 2022, it has allowed $25 billion in U.S. Treasury bonds of various maturities and $35 billion in MBS to mature each month without reinvestment as part of the central bank's balance sheet reduction process.

Compared to the initial pace of $60 billion in Treasury bond reduction per month, the current pace of balance sheet reduction has significantly slowed due to the increasing pressure from U.S. Treasury bond repayments and interest payments, as well as the inflation-fighting process nearing its end.

It is understood that in January of this year, the U.S. government's outstanding debt reached the statutory limit, after which the U.S. Treasury has been taking so-called "extraordinary fiscal measures" to expand its ability to pay federal government expenditures, including debt interest, relying on its cash reserves In response to questions about the U.S. government debt ceiling, Logan stated that if the U.S. Treasury quickly rebuilds its main account, the Federal Reserve will face "a significant issue," noting that the spread between money market rates and the Interest on Reserve Balances (IORB) is a key metric.

"The focus is that currently, money market rates are far below the IORB, and all other indicators that the Fed staff are reviewing suggest that we have not yet reached this adequate and sufficient level," Logan said in an interview. "Therefore, any such decision does not imply a halt to the Fed's balance sheet reduction process."

Market participants have recently bet in advance on the timing of the end of the Fed's balance sheet reduction, with some institutions speculating based on the minutes from the Fed's meeting on January 28-29 that the Fed might pause the balance sheet reduction process before Congress resolves the debt ceiling dispute, rather than in the second half of this year as previously expected. Logan did not mention a specific timeline for slowing or pausing the balance sheet reduction in her prepared remarks.

The latest Fed meeting minutes also revealed that Fed policymakers have begun to study new designs or optimization adjustments for the secondary market U.S. Treasury purchase mechanism after the end of balance sheet reduction. Several Fed officials support asset allocation based on the structural proportion of circulating Treasuries, which resonates with the duration matching theory proposed by Logan, as the current proportion of short-term Treasuries in the U.S. Treasury market is higher than the historical average.

The Dallas Fed President Logan's signal that the Fed may begin to expand its balance sheet and potentially increase its holdings of short-term Treasuries undoubtedly stems from the growing pressure of interest and principal payments on the U.S. government's massive debt.

Statistics compiled by institutions show that nearly $3 trillion in U.S. Treasuries will mature in 2025, most of which are short-term Treasuries. The U.S. Treasury has been issuing a large amount of such Treasuries in recent years, as they are highly liquid and therefore quite popular. However, the massive short-term Treasuries have significantly increased the U.S. Treasury's total debt to $36 trillion in just a few years, which has also led to a soaring budget deficit and record-high interest payments on U.S. debt.

Returning to the White House, Trump faces immense pressure from U.S. debt repayments at the start of his second term, while the Biden administration, known for its extravagant spending, has seen an unprecedented increase of over $8 trillion in U.S. debt issuance over the past three fiscal years, undergoing a process of "brutal expansion." The debt problem facing the U.S. government seems to imply that the bond market crash in 2024 is not bad enough, as U.S. debt investors who experience a sharp decline in Treasury prices in the second half of 2024 will face multiple challenges in the coming year, including a powerful and confidence-threatening "time bomb": the massive amount of short-term Treasuries maturing soon.

In fiscal year 2024, the U.S. government's net interest payments have already reached $882 billion, with interest payment growth hitting a record 34%, making it the third-largest expenditure item in the budget, second only to Social Security and healthcare, and even surpassing defense spending in fiscal year 2024. According to projections from the Congressional Budget Office (CBO), the budget deficit will expand significantly to $2.9 trillion in fiscal year 2034, with a cumulative budget deficit of $22 trillion from fiscal years 2025 to 2034; The CBO also predicts that net interest expenditure will reach a historical high in the fiscal year 2025, approaching $1 trillion, accounting for 3.4% of GDP, surpassing the historical record of 3.2% set in 1991; it is expected that by the fiscal year 2034, net interest expenditure will reach nearly $1.7 trillion, accounting for 4.1% of GDP.

Adequate Reserves System

As one of the strong supporters of the "Adequate Reserves System" established after the 2008 global financial crisis, Dallas Federal Reserve President Lorie Logan reiterated her firm support for this framework. "Although it is theoretically still possible to implement monetary policy through scarce reserves, the evolution of market structure in the post-crisis era has made precise control of reserve supply more challenging," she analyzed. "The Adequate Reserves System significantly simplifies the interest rate control mechanism and effectively reduces the frequency and precision requirements of operations for central banks like the Federal Reserve to respond to fluctuations in reserve supply and demand."

Major global central banks are advancing innovations in monetary and interest rate policy frameworks in the post-financial crisis era. Although the reform paths of the European Central Bank, Bank of England, Reserve Bank of Australia, and Reserve Bank of New Zealand differ, Logan pointed out that the management of central bank balance sheets is showing typical characteristics of convergence. "The apparent differences essentially reflect the adaptive adjustments of each central bank to the local financial ecosystem," she emphasized in her speech.

Logan also suggested developing new types of discount window tools to eliminate the stigma effect of commercial banks using emergency loan tools through a daily fixed-amount auction mechanism. However, this hawkish Federal Reserve official clearly opposed calls to revive and restore the federal funds overnight lending market, stating, "Only a significant spread between money market rates and reserve rates could potentially activate the interbank market, but this would severely damage the transmission efficiency of the Federal Reserve's monetary policy."

If the Federal Reserve stops this round of balance sheet reduction, global financial markets may welcome a "liquidity boon"

Generally speaking, the Federal Reserve's direct purchase of bonds (i.e., quantitative easing, abbreviated as QE, also known as "balance sheet expansion") or stopping balance sheet reduction (i.e., halting the process of reducing the balance sheet) both imply a significant improvement and promotion of liquidity in the financial markets. When the Federal Reserve purchases bonds, it is essentially exchanging the bonds held by banks for cash. This cash is deposited into the banking system in the form of bank reserves, increasing the supply of funds within the banking system. This means that banks can provide more loans, thereby promoting investment and consumption. Additionally, by purchasing long-term bonds, the Federal Reserve drives up the prices of these bonds and lowers their yields (i.e., long-term interest rates in the financial market), and lower long-term rates encourage businesses and consumers to borrow, stimulating economic activity.

Stopping balance sheet reduction means that the Federal Reserve will no longer decrease its balance sheet but will continue to hold or repurchase maturing bonds. When the Federal Reserve stops balance sheet reduction, the level of reserves in the banking system will not decrease and may even significantly increase, indicating that liquidity in the market is becoming more accommodative, and banks' lending capacity is also greatly enhanced.

The Federal Reserve's balance sheet reduction typically leads to high expectations for long-term interest rates due to increased bond supply in the market, while stopping balance sheet reduction avoids upward pressure on long-term interest rate expectations in the U.S., allowing the financial system to continue supporting economic activity. Therefore, through direct bond purchases or announcing a halt to balance sheet reduction, the Federal Reserve's monetary policy influence and expectation management mechanisms are sufficient to significantly expand liquidity in the financial system, lower long-term interest rates, boost prices of risk assets such as stocks, and stimulate the economy by enhancing market confidence