How the Fed Could Build a Treasury Market War Chest Without Expanding Its Balance Sheet

Why Treasury Market Resilience Is Critical After the 2020 Dash for Cash

The March 2020 “dash for cash” revealed a fundamental vulnerability in the world’s most important government bond market. As investors scrambled for liquidity, even U.S. Treasury securities—traditionally the ultimate safe haven—experienced severe price dislocations and trading disruptions. The Federal Reserve’s response was unprecedented: $850 billion in Treasury purchases executed in just two weeks to restore market functioning.

This crisis highlighted a critical gap between structural reforms designed to prevent market dysfunction (ex ante measures) and the official sector’s readiness to intervene when acute stress occurs (ex post measures). While regulatory improvements and market structure enhancements continue, central bank preparedness for emergency intervention remains essential.

New Federal Reserve research by Thomas Edge and Lihan Li proposes an innovative solution: restructuring the Fed’s System Open Market Account (SOMA) Treasury portfolio to create a permanent “war chest” for market-functioning purchases. Unlike traditional quantitative easing, this approach would enable rapid intervention without expanding the Fed’s balance sheet or increasing bank reserves—addressing both the mechanics of crisis response and the political economy concerns surrounding Fed asset purchases.

The key insight is deceptively simple. By tilting the SOMA portfolio toward short-term Treasury bills rather than maintaining the current “proportionate” allocation, the Fed would generate larger monthly maturities that could be redirected toward stressed coupon securities during crises. This war chest mechanism leverages the natural turnover of Treasury bills to create intervention capacity without the need for new money creation or balance sheet expansion.

The Proportionate Portfolio’s Hidden Limitations and False Precision

The Federal Reserve currently aims to hold Treasury securities in roughly the same maturity proportions as outstanding Treasury debt—approximately 20% bills and 80% notes and bonds. This “proportionate portfolio” approach is widely considered the most neutral allocation, minimizing the Fed’s influence on relative pricing across the yield curve.

However, Edge and Li’s research reveals that the proportionate portfolio has never been formally optimized and may not actually represent the most neutral option. The assumption that market functioning strains correlate directly with the Fed’s share of holdings at each maturity ignores the crucial role of price-inelastic investors—insurance companies, pension funds, and foreign central banks—whose behavior during stress episodes differs markedly from price-sensitive traders.

Moreover, the relationship between SOMA holdings and market functioning is likely non-linear. The research suggests a broad range of maturity compositions around the proportionate portfolio would carry essentially identical market functioning risks. The Fed has already demonstrated this flexibility: for years, it held disproportionately more long-term securities without creating measurable market disruptions.

This evidence challenges the assumption that significant deviations from proportionality necessarily impose costs. If a moderate tilt toward bills carries minimal market functioning risk while substantially enhancing crisis preparedness, the proportionate portfolio may represent a false precision that limits policy effectiveness. The research indicates that Federal Reserve balance sheet composition should optimize for crisis readiness rather than strict mathematical proportionality.

Building Monthly Firepower Through Bills Concentration

The war chest mechanism exploits a fundamental characteristic of Treasury bills: their frequent maturity dates create regular reinvestment opportunities. Unlike longer-term notes and bonds that may not mature for years, Treasury bills turn over weekly and monthly, generating a steady stream of principal payments that must be reinvested.

Under the current proportionate allocation (20% bills), the Fed receives approximately $385 billion monthly from maturing Treasury bills. During normal market conditions, this money is automatically reinvested in new bills to maintain the portfolio’s maturity structure. However, during a market crisis, the Fed could redirect these funds toward purchasing stressed coupon securities instead.

Each additional percentage point tilt toward bills adds roughly $19.2 billion per month to this intervention capacity. A modest increase to 30% bills would generate nearly $580 billion monthly, while a more aggressive 40% allocation would provide over $770 billion in monthly firepower. This scaling relationship allows policymakers to calibrate intervention capacity based on their assessment of tail risk scenarios.

The beauty of this approach lies in its balance sheet neutrality. Traditional large-scale asset purchases expand the Fed’s balance sheet and increase bank reserves, raising questions about monetary policy accommodation and complicating the unwinding process. The war chest mechanism simply reallocates existing holdings without creating new money or changing the overall size of the Fed’s portfolio.

This distinction proves crucial for maintaining clear separation between market-functioning interventions and monetary policy easing. By keeping the balance sheet constant, the Fed can address acute liquidity stress without sending mixed signals about its interest rate intentions or triggering political concerns about quantitative easing through the back door.

Sizing the War Chest for Different Crisis Scenarios

Calibrating the optimal bills allocation requires confronting an uncomfortable question: how extreme was March 2020, and how much of the distribution of potential stressed sales should the Fed be prepared to cover? The research provides concrete benchmarks for answering this critical policy question.

The March 2020 episode saw approximately $840 billion in private-sector Treasury sales during the first quarter, representing roughly 4.5% of outstanding marketable Treasury securities. Scaling this percentage to today’s $26 trillion Treasury market suggests potential stressed sales of approximately $1.2 trillion in a comparable crisis.

To cover purchases of this magnitude entirely through the war chest mechanism would require approximately 60% of the SOMA portfolio in Treasury bills—triple the current proportionate allocation. While mathematically feasible, such an extreme concentration might create its own market functioning risks and would represent a dramatic departure from current practice.

More reasonable scenarios suggest bills portfolio shares of up to 40% could provide substantial crisis capacity while maintaining market neutrality. Using generalized Pareto distributions to model tail risk scenarios, the research finds that a 40% bills allocation could cover stressed sales in all but the most extreme percentiles of potential crisis episodes.

The optimal tilt ultimately depends on policymaker judgment about two key factors: first, their assessment of whether March 2020 represented a once-in-a-generation shock or a preview of more frequent future disruptions; and second, their preferred coverage level for the distribution of potential crisis scenarios. Historical analysis of quantitative easing programs suggests that partial coverage combined with market confidence in the Fed’s intervention capacity may provide disproportionate stabilization benefits.

Financial Stability Trade-Offs and New Risks

Concentrating more Treasury bills in the Fed’s portfolio necessarily means fewer bills available to private investors, raising important questions about financial stability implications. The primary historical concern has been that reduced bill supply might drive investors toward unstable private money-like assets, potentially destabilizing money markets.

However, post-global financial crisis reforms to money market funds have substantially mitigated these risks. New regulations requiring government money market funds to invest primarily in Treasury and agency securities, combined with improved liquidity management requirements, have reduced the sector’s vulnerability to runs and its reliance on private repo markets.

The more significant concern involves the flip side of the equation: more coupon securities held by leveraged private investors. If hedge funds and other leveraged investors absorb the additional coupon securities displaced by the Fed’s bills tilt, it could expand the cash-futures basis trade—a highly leveraged strategy that was implicated in the March 2020 crisis.

The basis trade involves purchasing Treasury coupon securities and shorting futures contracts to capture small pricing differentials. During the March crisis, margin calls on these positions forced massive deleveraging that contributed to the very market dysfunction the war chest strategy aims to address. A bills-tilted portfolio could potentially amplify this vulnerability by increasing the supply of coupon securities that typically fund such strategies.

The research also considers potential yield curve effects from bills concentration. A persistent bills tilt could theoretically steepen the yield curve by reducing Fed demand for longer-term securities. However, empirical evidence from the Maturity Extension Program suggests these effects may be smaller than theoretical models predict. The MEP involved $670 billion in sales of short-term securities and purchases of long-term bonds over 15 months, yet measured yield curve impacts were relatively modest.

Moral hazard presents another consideration: if market participants expect the Fed to intervene during stress episodes, they may take additional risks or provide less private liquidity during normal times. However, given the already established precedent of Fed intervention in Treasury markets, the incremental moral hazard from enhanced preparedness likely remains limited. Systemic risk management frameworks typically conclude that crisis preparedness benefits outweigh moral hazard costs when intervention expectations already exist.

Money Market Effects During War Chest Deployment

When the war chest strategy is deployed during a crisis, the Fed would abruptly reduce its reinvestment in new Treasury bills, redirecting those funds toward stressed coupon securities instead. This sudden change in bill demand could create ripple effects throughout money markets, potentially undermining the balance sheet-neutral design of the strategy.

The magnitude of this impact depends on the scale of intervention and the duration of the deployment. During the March 2020 crisis, the Fed purchased approximately $850 billion in Treasury securities over two weeks. If executed entirely through war chest reallocation, this would have eliminated bill reinvestments for more than two months under a proportionate portfolio, or about six weeks under a 40% bills allocation.

Such an abrupt reduction in bill demand could pressure money market rates higher as other investors must absorb the additional supply. This tightening could partially offset the intended easing effects of the coupon purchases, though the net impact would likely still be stabilizing given the acute stress in coupon markets that would trigger the intervention in the first place.

Treasury bills’ inherent flexibility provides some natural buffering against these effects. Bill markets typically see substantial variations in demand and supply as investors adjust their cash management strategies and the Treasury varies its issuance patterns. The additional volatility from Fed war chest deployments would represent an incremental rather than unprecedented source of money market variation.

The Rebuilding Challenge After Major Interventions

One of the most challenging aspects of the war chest strategy involves rebuilding intervention capacity after a major deployment. Unlike traditional quantitative easing programs that can be unwound through asset sales, the war chest mechanism requires gradually restoring the bills allocation through the natural turnover of the purchased coupon securities.

The timeline for passive restoration varies dramatically based on the initial portfolio composition. A proportionate portfolio (20% bills) that depleted its entire war chest would require approximately 2.5 years to rebuild through natural maturities and reinvestment in bills. A 30% bills portfolio would need roughly 4 years, while a 40% allocation would require about 5.5 years for full restoration.

These lengthy rebuilding periods create extended vulnerability windows during which the Fed would be under-provisioned for subsequent crises. Historical analysis reveals that while large SOMA market-functioning purchases have been rare—occurring only four times in 80 years (1939, 1958, 1970, 2020)—episodes of sudden Treasury market depth deterioration have been much more frequent, with approximately 13 occurrences in the 17 years since the global financial crisis.

This frequency mismatch suggests that passive restoration may leave dangerous gaps in crisis preparedness. The Fed might deploy its war chest during a moderate stress episode, only to face a more severe crisis before rebuilding capacity. Such scenarios would force either balance sheet expansion (undermining the strategy’s political economy benefits) or inadequate intervention (risking market dysfunction).

Active restoration through sales of previously purchased coupon securities could accelerate the rebuilding process but introduces new complications. Selling large quantities of coupon securities might depress prices and send mixed signals about the Fed’s policy intentions. The timing and pace of such sales would require careful calibration to avoid creating new market disruptions while rebuilding crisis capacity.

The research suggests that distinguishing market-functioning purchases from quantitative easing monetary policy may require more aggressive unwinding timelines than traditional QE programs. This imperative could favor moderate bills tilts that provide substantial crisis capacity while maintaining manageable rebuilding requirements, rather than extreme allocations that create multi-year vulnerability periods.

Comparing Alternative Market Intervention Proposals

The war chest approach represents one of several recent proposals for enhancing Treasury market resilience through official sector intervention. Each approach offers distinct advantages and trade-offs that illuminate the broader policy challenge of crisis preparedness.

Kashyap, Stein, Wallen, and Younger (2025) propose that the Fed engage in hedged cash-futures basis trades during stress periods, purchasing Treasury coupon securities while simultaneously selling futures contracts to keep the term premium unchanged. This approach would expand the balance sheet but avoid the yield curve effects that typically accompany large-scale asset purchases.

The hedged approach offers precision in targeting specific market dysfunction without broader monetary policy implications. However, it requires sophisticated derivatives operations that may prove challenging to execute rapidly during crisis periods. It also expands the balance sheet, triggering the same political economy and unwinding complications that the war chest strategy seeks to avoid.

Duffie and Keane (2023) propose fiscal authority buybacks, with the U.S. Treasury purchasing coupon securities funded through new bill issuance or existing cash balances. This approach preserves central bank independence by keeping intervention authority with the fiscal authority, avoiding any expansion of the Fed’s balance sheet or policy role.

However, operational capacity represents a significant limitation of the fiscal approach. The Treasury’s current liquidity buyback program operates at a maximum scale of approximately $38 billion per quarter—far below the $850 billion that the Fed deployed in two weeks during March 2020. Scaling Treasury operations to crisis intervention levels would require substantial institutional development and advance preparation.

All three approaches share important common ground: recognition that the official sector must be prepared for market-functioning asset purchases, and emphasis on distinguishing such interventions from monetary policy accommodation. The war chest approach offers balance sheet neutrality and existing operational capacity, while the alternatives provide different combinations of policy independence, market precision, and institutional constraints.

Rather than viewing these as competing proposals, policymakers might consider them as complementary tools in a comprehensive crisis response framework. The war chest provides immediately available capacity, fiscal buybacks offer longer-term institutionally neutral intervention, and hedged purchases enable precise targeting of specific market dysfunctions. Treasury market structure complexities may require multiple intervention mechanisms rather than reliance on any single approach.

Historical Lessons from the Bills-Only Era

The war chest proposal echoes historical debates about Federal Reserve operations that date back to the early 1950s. Following the Treasury-Federal Reserve Accord of 1951, which ended the Fed’s commitment to support government bond prices, Chairman William McChesney Martin advocated limiting Fed operations to Treasury bills only.

Martin’s “bills-only” philosophy reflected a principled position about central bank market intervention. He argued that the Fed should influence only the short end of the yield curve through bill operations, allowing market forces to determine longer-term interest rates without direct central bank interference. This approach would minimize Fed distortions in credit allocation while maintaining monetary policy effectiveness.

The bills-only doctrine dominated Fed operations from 1953 to 1961, when the Kennedy administration’s concerns about balance of payments and long-term interest rates led to renewed Fed operations across the yield curve. However, the underlying philosophy—that central bank market footprint should be minimized while maintaining crisis response capacity—remains relevant to contemporary debates.

A modern bills-tilted portfolio embodies a similar philosophy adapted to current institutional realities. Rather than limiting operations exclusively to bills, the approach concentrates holdings in bills while maintaining flexibility for crisis intervention across the yield curve. This preserves the market neutrality benefits that Martin sought while addressing the intervention preparedness that the 2020 crisis demonstrated as essential.

The historical precedent also illustrates the importance of communicating the rationale for portfolio composition. Martin’s bills-only approach succeeded partly because it was grounded in a clear philosophy about central bank market intervention that market participants could understand and anticipate. A contemporary bills tilt would similarly require clear communication about crisis preparedness objectives and the conditions that would trigger war chest deployment.

Practical Implementation and Policy Implications

Implementing a bills-tilted portfolio would require addressing several practical considerations beyond the core strategic decision. Portfolio composition represents just one element of comprehensive SOMA management, which must also consider asset-liability management, effective lower bound preparedness, debt management coordination, and operational capacity constraints.

The Treasury’s Debt Management Office could potentially offset some effects of Fed bills concentration by adjusting its issuance patterns. If the Treasury increased bill issuance when the Fed concentrated bill holdings, it could maintain the total supply of bills available to private investors. However, the research analysis assumes no such coordination, providing a conservative assessment of market effects.

A bills tilt would also enhance the Fed’s capacity for maturity extension programs—operations that exchange short-term securities for longer-term holdings to provide monetary accommodation without expanding the balance sheet. The larger stock of bills would provide more ammunition for such programs, adding to the crisis response toolkit beyond market-functioning purchases.

Communication challenges represent a significant implementation hurdle. Market participants have become accustomed to the proportionate portfolio as a baseline for Fed operations. Deviating from proportionality would require clear explanation of the crisis preparedness rationale and the specific conditions that would trigger war chest deployment to avoid market confusion or unintended signaling effects.

The transition timeline also requires careful consideration. An abrupt shift to a bills-heavy portfolio could create temporary market disruptions as participants adjust their expectations and positioning. A gradual transition over several years would allow market adaptation while building crisis capacity progressively.

Market participants would need to adjust their own risk management and positioning strategies based on the reduced availability of bills and increased supply of coupon securities. Money market fund regulations and bank liquidity management practices might require updates to accommodate the changed Treasury market structure.

The war chest approach to Treasury market intervention represents a significant evolution in thinking about Federal Reserve crisis preparedness. By recognizing that portfolio composition itself can serve as a policy tool, it offers a pathway to enhanced market resilience without the political economy complications of traditional large-scale asset purchases.

Most fundamentally, the war chest concept highlights the importance of advance preparation for crisis intervention. The 2020 experience demonstrated that crisis response cannot rely solely on improvisation and escalation. Having predetermined capacity and clear operational frameworks allows for more effective and timely intervention when market functioning deteriorates rapidly.

As Treasury markets continue to evolve and grow, the official sector’s crisis response capacity must evolve correspondingly. The war chest approach offers one promising direction for this evolution, providing enhanced preparedness while maintaining the institutional and political constraints that govern central bank operations in democratic societies. The challenge for policymakers lies in calibrating the approach to balance intervention capacity with other portfolio management objectives and market functioning considerations.