Dongxing Securities Co., Ltd.: The market has misconceptions about Waller's "hawkish" interpretation, expects "Waller trades" to have reversal risks but the timing may need to wait until May

Dongxing Securities published a report stating that recently, influenced by the turmoil surrounding the Federal Reserve Chair candidate, Trump's statements on dollar exchange rate intervention, and the situation in Iran, gold and silver precious metals surged and then plummeted. The firm believes that the market has a clear misunderstanding of the future "hawkish" interpretation of Federal Reserve Chair nominee Waller, and expects that after Waller takes office, there will be more interest rate cuts within the reasonable range of the Taylor Rule than the market anticipates, while his views on balance sheet reduction do not have the conditions to be implemented in the current dollar liquidity environment. However, the market may still have to wait until May 16, when Waller officially takes office as the new Federal Reserve Chair, for a reversal of the "Waller trade," at which point short-term U.S. Treasury yields may decline, while long-term U.S. Treasury yields may rise due to the term premium brought about by the trading reversal.

The firm anticipates that there is a risk of reversal in the "Waller trade," but the timing may wait until May. Firstly, from his latest views, Waller's stance on "balance sheet reduction" is, on one hand, more about expressing opposition to the unlimited expansion of the Federal Reserve's balance sheet, and on the other hand, Waller believes that U.S. inflation is not due to an overheating economy, and balance sheet reduction can also indirectly pave the way for interest rate cuts; secondly, Waller's personal relationship with Trump makes him more inclined to maintain "alignment" with Trump in the execution of monetary policy; finally, under the current dollar liquidity environment, the Federal Reserve does not have the conditions for balance sheet reduction. If Waller immediately starts balance sheet reduction after taking office, leading to a liquidity crisis similar to that of 2019, it would be detrimental to the smooth implementation of subsequent policies.

Based on Waller's latest views, Trump's considerations regarding Waller's nomination, and the feasibility of future balance sheet reduction, Dongxing Securities believes that the market has a clear misunderstanding of Waller's "hawkish" interpretation, and there is a risk of reversal in the "Waller trade." Firstly, from his latest views, since 2025, Waller has continuously expressed views on inflation, believing that inflation is a "choice"; if the government prints too much money, there will be structural inflation; "the current bloated balance sheet of the Federal Reserve is essentially designed to respond to a crisis era that has long passed, used to support the largest financial institutions, and its scale can be significantly reduced; this released policy space can be redirected to the household sector and small and medium-sized enterprises in the form of lower interest rates, thereby providing substantial support to them." In summary, Waller's views on "balance sheet reduction" are, on one hand, more about expressing his opposition to the unlimited expansion of the Federal Reserve's balance sheet during the Powell, Yellen, and even Bernanke eras, and on the other hand, Waller believes that inflation does not arise from an overheating economy, but is a "choice" of the government, thus balance sheet reduction can indirectly pave the way for interest rate cuts.

The firm believes that the Federal Reserve currently does not have the conditions for balance sheet reduction. The lightweight "balance sheet expansion" RMP (Reserve Management Purchases) initiated by the Federal Reserve in December last year was in response to the current dollar liquidity facing the exhaustion of the reverse repurchase "buffer," and the increasing frequency of liquidity tools being used for reverse repurchase, with bank reserves also beginning to face substantial impacts as balance sheet reduction progresses. In such an environment, the quantitative expansion of the balance sheet initiated by the Federal Reserve is to avoid the potential emergence of a liquidity crisis in the repurchase market. If Waller immediately starts balance sheet reduction after taking office, leading to a liquidity crisis similar to that of 2019, it would be very detrimental to the smooth implementation of subsequent policies Looking ahead, regarding the Federal Reserve's policy framework during the tenure of Walsh, the bank believes that it is difficult for the Federal Reserve to truly return to the situation of the 1970s where the Federal Reserve Chairman "only follows the president's orders." What Walsh can do is to achieve more interest rate cuts within the "rules of the game" of the Federal Reserve, which is professionally termed the Taylor Rule. Therefore, the bank believes that after Walsh takes office as Federal Reserve Chairman, there will still be more interest rate cuts within the reasonable range of the Taylor Rule than the market expects. However, since Walsh's nomination needs to be reviewed by the Senate, and Trump hopes to avoid any influence on his "control" over the Federal Reserve after Chairman Powell's departure, Walsh will maintain an independent image in public from February to April. The market may have to wait until May 16, when Walsh officially takes office as the new Federal Reserve Chairman, for a reversal of the "Walsh trade."