In both the United States and Japan, monetary policy is expected to support fiscal policy, even when central banks have other plans in mind. Kevin Warsh, the vision of the newly appointed chair of the Federal Reserve of the United States (Fed), is to create an “ideal Fed.” However, his restructuring plans directly oppose the desire of US President Donald Trump to keep interest rates low. Similarly, the Bank of Japan (BoJ) aims to normalise interest rates and reduce its balance sheet. However, this clashes with the priorities of Prime Minister Sanae Takaichi, as she seeks the central bank's support for her economic policies.
Trump eclipses the Fed: Kevin Warsh’s vision of an “ideal Fed”
Kevin Warsh faces a titanic task, as he aims to create the “ideal Fed” while maintaining favourable financing conditions, all while re-evaluating the collaboration between the Fed and the US Treasury. Each of these goals may seem reasonable in theory, but their joint application could prove counterproductive in practice.
Warsh believes that monetary policy should be based on convictions rather than determined by data or forecasts. However, this approach would increase the likelihood of prolonged periods of excessively loose monetary policy, which could lead to an increase in long-term interest rates. One of Warsh's convictions is that productivity gains driven by artificial intelligence could allow for greater economic growth without causing inflation. Furthermore, Warsh advocates for less transparency, meaning less communication from members of the Federal Open Market Committee (FOMC). This lack of clarity could increase uncertainty among market participants regarding monetary policy, leading to greater interest rate volatility and potentially increasing the term premium. Additionally, Warsh has been a staunch opponent of balance sheet operations, such as quantitative easing (QE), which has historically focused on the long end of the yield curve and contributed to its flattening. In our opinion, these proposed reforms for the Fed are factors that would lead to a steeper yield curve, essentially the opposite of the favourable financing conditions Warsh aims to achieve.
As if the task of reducing interest rates, according to his vision of an “ideal Fed,” were not overwhelming enough, Warsh also intends to reorient the Fed's collaboration with the US Treasury. In his view, the 1951 Accord conflicts with current practices, as the distinction between the central bank and the fiscal authority has become increasingly blurred. Consequently, Warsh has called for a new agreement to create a framework that allows the Fed and the Treasury, possibly in collaboration with the mortgage agencies Fannie Mae and Freddie Mac, to jointly address the reduction or adjustment of the size and composition of the balance sheet.
One approach to reducing the balance sheet could involve gradually replacing maturing long-term bonds with shorter-term securities, such as Treasury bills (T-Bills). Alternatively, the mortgage-backed securities (MBS) portfolio could be swapped for Treasury bills, in line with recent announcements from Fannie Mae and Freddie Mac regarding their plans to acquire MBS to help reduce mortgage costs. This coordinated effort aims to minimise market volatility while reducing the balance sheet. To offset the resulting tightening of financial conditions, Warsh might consider lowering official interest rates.
Warsh frequently highlights the importance of Federal Reserve independence, but he also argues that fiscal policy should drive economic growth through low taxes and limited regulation, while monetary policy should focus on fostering investment by keeping interest rates low. This perspective evokes comparisons with the mid-1960s, when the Federal Reserve, under the leadership of William McChesney Martin Jr., took a more favourable stance towards fiscal policy. However, we believe that such alignment between monetary and fiscal policy could, in practice, undermine the Fed’s independence. The assumption that greater economic growth alone can stabilise deficits, despite increased defence spending and the ongoing issuance of government bonds, is likely to push term premiums higher, especially if it coincides with concerns about the erosion of the Fed’s independence.
In contrast, Donald Trump’s economic agenda places special emphasis on housing affordability, particularly focusing on achieving lower mortgage rates. However, both a Federal Reserve balance sheet reduction and a shortening of the maturity structure, as mentioned earlier, would exert upward pressure on US Treasury yields and, by extension, on mortgage rates. We believe that this highlights a clear conflict between Warsh’s proposed plans and the objectives of the Trump Administration. While Warsh argues that a reduced role for the central bank in the public debt market could promote fiscal discipline and ultimately lead to lower long-term interest rates, this perspective seems to overlook one fact: initially, higher long-term interest rates would be necessary to restore fiscal discipline.
Despite the surge in oil prices, we expect the Federal Reserve to cut interest rates in 2026. Prior to the rise in oil prices, the federal funds rate was at 3.75%, above the neutral range of 2.5% to 3.5%, thus remaining slightly restrictive. In a context of a weakening labour market, our opinion aligned with the market consensus that at least two rate cuts (of 25 basis points each) would occur in 2026. However, the market now assumes that there will be no rate cuts this year. Despite this shift in market expectations, we still believe that at least two rate cuts will occur in 2026. However, we see limited potential for further declines in long-term yields, which will likely result in a steeper US yield curve. Additionally, we expect the US dollar to weaken in this scenario.
The divergent paths of Sanae Takaichi and Kazuo Ueda
In bond markets, good news is often bad news. When the economy is doing well, bond prices tend to fall and interest rates rise. As a result, borrowing becomes more expensive for borrowers. This dynamic is particularly significant for Prime Minister Sanae Takaichi, at the helm of one of the world’s largest debtors.
Following her crushing victory in the early elections in February, which secured her Liberal Democratic Party (LDP) a two-thirds majority, Takaichi now faces considerable pressure to implement ambitious reforms. With this qualified majority in the upcoming House of Representatives, the LDP will gain full control of all parliamentary committees, including the influential budget committee. This dominant position allows the party to pursue its vision of “responsible and proactive” fiscal policy without needing to negotiate compromises with opposition parties.
The bond market is expected to scrutinise the government’s initial policy proposals to assess how the LDP plans to practically balance “proactive” measures with “responsible” fiscal management. In recent years, the Japanese government has been working to consolidate its budget, aiming to limit new debt issuance to approximately 2% of GDP by 2026. However, during her tenure at the helm of a minority government, Takaichi had already indicated her willingness to expand this deficit. Therefore, the details of her fiscal plans, which will be clarified in the coming weeks, are highly anticipated.
Japan's gross public debt recently surpassed 200% of GDP, a level significantly higher than that of most other developed countries. This high debt ratio did not pose a significant concern for many years, as interest rates in Japan remained near zero. Additionally, the Bank of Japan played a key role in keeping interest rates low by implementing its quantitative easing programme, during which it systematically purchased more government bonds than the government issued.
However, in recent years, rising inflation has led the Bank of Japan to gradually raise official interest rates and reduce its bond purchases, acquiring fewer new bonds than those that mature. In the past two years, this shift has resulted in a steady decline in the Bank of Japan's bond portfolios. Consequently, the refinancing costs of government bonds have increased, which could exert greater pressure on the national budget in the coming years. Since late 2022, the yield on Japanese government bonds (JGB) with a 10-year maturity has risen sharply, increasing by nearly 200 basis points, from 0.25% to 2.2%. As a result, interest expenses are expected to rise significantly in the near future.
Like the US government, Prime Minister Sanae Takaichi advocates for a more accommodative fiscal policy and has called on the central bank, under the leadership of Kazuo Ueda, to keep interest rates low to encourage investment and support ambitious spending plans. Nonetheless, we anticipate a gradual increase in official interest rates as part of the ongoing normalisation of monetary policy. In this context, 10-year yields are expected to approach 2.5%, especially if political priorities remain undefined until 2027 and fiscal uncertainties persist.
Although real 10-year yields in Japan have recently turned positive, we believe they remain less attractive compared to real yields in the US or the eurozone. Furthermore, net issuance of long-term bonds is expected to increase significantly. As the Bank of Japan (BoJ) continues to reduce its bond purchases, net issuance of Japanese government bonds (JGB) to the private sector is expected to rise this year.
In a context of sustained wage growth of 5%, we expect the Bank of Japan to implement two additional rate hikes of 25 basis points, bringing the official interest rate to 1.25% by the end of 2026. As a result, the Japanese yield curve is likely to experience a downward flattening.
Lagarde's "good timing" is at risk
The restructuring of the Federal Reserve, along with the US interest rate cuts we anticipate, is likely to weaken the dollar against the euro. This could dampen inflation in the eurozone, as import prices (especially for commodities and energy) are likely to fall, while the competitiveness of European exports could be negatively affected. Additionally, Chinese products, which could be redirected to the European market due to lower demand in the US, could exert downward pressure on prices.
At the same time, it remains unclear whether economic growth in the eurozone will be strong enough to prevent inflation from falling too far below the European Central Bank's (ECB) target of 2%.
Before the conflict with Iran, the European monetary authority considered itself to be “in a good position” and initially we aligned with market expectations that there would likely be no further adjustments to official interest rates in 2026. However, the ECB's track record reflects a series of so-called “policy errors,” and the market now expects that the institution will have no choice but to raise interest rates in response to rising inflation. If the duration of the conflict extends beyond the 4 to 6 weeks from the time of writing this report (before the current ceasefire), it is very likely that the ECB will implement two rate hikes this year. This is especially plausible given that the current deposit rate of 2% is at the lower end of the neutral range, which spans from 2% to 3%.