What Fed Exit?

Bloomberg's Joshua Zumbrun has released a much overdue, MSM apocryphal, somewhat realistic outlook on the endspiel of Bernanke's central planning: i.e., the unwind of the Fed's balance sheet that from just under $3 trillion will reach $5 trillion by the end of 2014. We say "somewhat" because the conclusion in the article is that there is some hope still for an orderly wind down of the Fed's assets without a complete market collapse. The reality is that there is no such hope.

As we have explained previously, the market now demands roughly $85 billion in ten year equivalent "Flow" per month injected by the Fed: this was what QEternity allowed the market to price in as the basis level for the future and is why we knew with 100% certainty that Twist would be extended the day it was announced on Sept 13, only without the offsetting sale of ZIRP-umbrella securities (which are irrelevant from a 10-year duration standpoint), a forecast that has now been adopted by everyone. In plain English: the market needs the Fed to inject $85 billion each month just to stay level, never mind grow (sure enough, the market highs for 2012 were hit the day after QEternity was announced, confirming the market will need to see even more monthly flow to continue rising).

Anyway, some of Zumbrun's key highlights:

A decision by the Federal Reserve to expand its bond buying next week is likely to prompt policy makers to rewrite their 18-month-old blueprint for an exit from record monetary stimulus.


Under the exit strategy, the Fed would start selling bonds in mid-2015 in a bid to return its holdings to pre-crisis proportions in two to three years. An accelerated buildup of assets would also mean a faster pace of sales when the time comes to exit -- increasing the risk that a jump in interest rates would crush the economic recovery.



The bigger the balance sheet, “the riskier the exit becomes,” Richmond Fed President Jeffrey Lacker said during a Nov. 20 speech in New York. “That is something we need to think carefully about.”


Krishna Memani, director of fixed income at OppenheimerFunds Inc., said a too-rapid sale of assets risks disrupting the $5.2 trillion market for agency mortgage debt.



“They have to find ways of unwinding the balance sheet without dumping all of it in the marketplace,” said Memani, who oversees a bond portfolio of about $70 billion, including about $6 billion of mortgage-backed securities.



“The more they add to the balance sheet, the longer it will take to normalize,” said Hanson, who worked on designing tools that will be used in the Fed’s exit strategy as an economist in the monetary affairs division at the Board of Governors in 2009.

“The exit is going to take a long time,” said Stephen Oliner, a resident scholar at the American Enterprise Institute in Washington and former Fed Board senior adviser. He estimates the Fed’s holdings could rise to more than $4 trillion.


If the Fed were to start bringing its holdings back to their pre-crisis level today, it would have to sell almost $2 trillion over a period of two to three years under its current exit plan. Assuming holdings grow to $4 trillion, asset sales could come to $3 trillion over the same period.
The Fed’s other tool is to extinguish reserves by selling bonds back to dealers. Even a fully-explained plan could push up home borrowing costs as traders account for hundreds of billions of dollars of new supply flowing back into the market.


“We are deep into experimentation at this point,” Oliner said. “It’s understandable that people are worried.”

All relevant and credible insights, which however can be summarized with one simple fact and an even simpler chart courtesy of Stone McCarthy.

The fact: "The measurement of duration risk translates to an average price decrease of approximately 7.65% for each percentage point increase in all yields." In other words a DV01 of well over $2 billion. So much for that total credible Fed "capital" of $55 billion which would be wiped following rates rising by a tiny 32 bps. But where it gets fun is extrapolating, because at the current rate the Fed's balance sheet will hit a 10 Year average duration by 12/31/2014, on $5 trillion in holdings. A DV01 of $5 billion, or $500 billion for a 1% rise in rates!

As for the chart:

The chart shows, without a doubt, that the Fed is now the sole monopolist of Treasury demand expressed in mid-modified duration - i.e., the risk parameter most relevant to the Fed as it attempts to push everyone into higher risk assets (when instead all it is doing is merely allowing everyone to frontrun it). It also shows that in the past 3 years, the Private Sector has had its exposure to US Treasurys grow by virtually a non-existent amount, a simple fact that would make the head of steeped in theory and clueless of actual practice hollow pundits, such as Paul Krugman, explode.

To put it simply, the Fed's QE can not stop as there is no real market, or demand for TSYs expressed in duration terms, a fact the Fed's 4 year meddling in the market has been able to conceal quite effectively. Alas, the Fed knows this. The Fed also knows that in a country which will continue piling up $1 trillion + deficits forever, there will always have to be a backstop funder of the US deficit. Since China is long gone as a buyer of US paper, this only leaves the Fed.

In other words, the simplest reason why the Fed will never exit is because the US will never again run a budget surplus, meaningless discussions over what a token $80 billion a year tax increase (which will fund the US deficit for 2-3 weeks) will do notwithstanding, and the Fed will need to monetize ever more US-sourced paper until Bernanke and his successor after 2014 are the only "market" for bonds left standing.