• Federal Reserve President Hammack emphasizes the U.S. government is on an unsustainable fiscal path while inflation remains "still too high" despite recent rate cuts.
  • The Fed is closely monitoring elevated hedge fund leverage in Treasury markets, with average gross leverage at historically high levels and basis trades driving record exposures.
  • Policy adjustments include shifting the Fed's balance sheet toward Treasury bills, with rate policy expected to remain on hold "for quite some time" amid ongoing financial stability concerns.

Federal Reserve President Hammack delivered a stark warning about the nation's fiscal trajectory while highlighting growing risks in Treasury markets, creating a complex backdrop for monetary policy as 2026 approaches. Speaking at a financial conference on Thursday, Hammack stated unequivocally that "the U.S. government is on an unsustainable fiscal path," even as he noted inflation pressures persist above target levels. His comments come as the Fed maintains what he described as a policy stance "in the vicinity" of neutral, positioned "to see how things play out" amid competing economic pressures.

What's particularly concerning to Fed officials, according to people familiar with their thinking, is the simultaneous buildup of leverage in Treasury markets. The Federal Reserve's November 2025 Financial Stability Report documented that average gross hedge fund leverage has reached historically high levels, with the top 10 hedge funds accounting for 40 percent of total repo borrowing and maintaining leverage ratios of 18 to 1 as of the third quarter. "We're watching for build up of leverage in Treasury market," Hammack acknowledged, pointing specifically to basis trades—strategies that involve long positions in cash Treasuries combined with short positions in futures to exploit pricing discrepancies.

Market participants who attended the conference described Hammack's tone as measured but clearly concerned. One portfolio manager, who requested anonymity to discuss private conversations, said the Fed appears "acutely aware" that high leverage in basis trading contributed to Treasury market instability during the 2020 financial turmoil and could pose similar risks now. The numbers are striking: hedge funds' long U.S. Treasury exposure has reached a record $2.4 trillion, representing approximately 10 percent of all U.S. Treasuries held by the private sector, with an additional $631 billion in interest-rate swap market exposures.

Efforts to address these interconnected challenges have already begun shaping policy decisions. The Federal Open Market Committee has been adjusting its balance sheet strategy, including decisions to increase the proportion of Treasury bills in its portfolio to enhance flexibility for future monetary policy accommodations. Beginning December 1, the Fed began reinvesting principal payments from agency securities into Treasury bills rather than longer-term securities—a technical move with significant implications for market functioning.

When reached for comment, a Treasury Department spokesperson declined to address Hammack's specific fiscal warnings but pointed to recent debt management reports emphasizing "prudent stewardship" of government financing. Market-based expectations for the federal funds rate at the end of 2026 have increased by about 80 basis points in recent weeks, reflecting growing uncertainty about how the Fed will navigate between fiscal sustainability concerns, persistent inflation pressures, and elevated financial sector leverage.

Research cited in the Fed's stability report has documented that growth in U.S. Treasury markets may be surpassing dealers' capacity to effectively and safely intermediate in both cash and repo markets—a structural concern that could amplify any market stress. The report concluded that "when taken together, the overall level of vulnerability due to financial sector leverage was notable," suggesting regulatory attention may intensify if current trends continue.

Hammack indicated that Fed rate policy could remain on hold "for quite some time," a stance that reflects the delicate balancing act between addressing inflation that remains "still too high" and managing financial stability risks that are building in plain sight. For now, market participants are parsing every word from Fed officials, aware that the convergence of unsustainable fiscal trends and record Treasury market leverage creates a policy environment with few easy solutions.