Why Unwinding the Fed’s Balance Sheet Could Get Messy
Stock trader and Bloomberg writer Vince Cignarella recently addressed the potential unwind of the Fed’s balance sheet, and said that ‘it could get messy.’
Cignarella said the Fed should watch what it says about its $4.5 trillion balance sheet, because a few mistimed words could affect the markets.
The Fed could use the balance sheet to help tighten policy. Ex Fed Chairman Ben Bernanke surprised the markets in 2013 when he said the Fed might cut back on monthly bond and mortgage-backed securities purchases by $10 billion. Traders panicked, and pushed the 10-year yield to nearly 3% from below 2% in four months, sparking a crisis in emerging markets.
This time could be worse. The Fed may announce a taper while they are increasing rates and in a bearish bond market, which could exacerbate any move because there are fewer buyers to absorb supply. Tapering a balance sheet of this size has never been done.
The Fed will also be tightening for the first time in more than a decade—raising the Fed Funds rate without draining reserves is repricing the curve, not tightening. Increasing rates changes the price of money in circulation; tapering reduces it.
John Williams of the San Francisco Fed said it won’t be disruptive when the Fed starts to let the balance sheet roll off, because it will cause rates to go up, which is ‘desirable.’ How much is desirable?
If markets don’t get the message, traders won’t wait. They will want to get ahead of the curve, and that could lead to a surge in yields.
Some analysts predict yields will rise 15 to 20 basis points, but that may just be on the first day. As traders will tell you, getting into a long position is easier than getting out.