Why Unwinding The Fed's Balance Sheet Could Get Messy

With former Fed chair Ben Bernanke becoming the latest academic to opine on the potential unwind of the Fed's balance sheet last week (naturally, he was against it realizing the potentially dire implications such a move could have on asset prices), here is the same topic as viewed from the perspective of an actual trader, in this case FX strategist (who writes for Bloomberg) Vincent Cignarella, and who believes that "unwinding the Fed's balance sheet could get messy."

Cignarella explains why the Fed better beware what it wishes for in his analysis below.

The Federal Reserve should watch what it says about its $4.5t balance sheet. With so much uncertainty in the market about how it will be reduced, a few mistimed words could roil markets faster than you can mouth “taper tantrum.”


The topic is hot. The Fed’s Bullard and Rosengren have recently said the central bank could use the balance sheet to help tighten policy and other bank presidents have also talked about tapering.  Ex-Chairman Bernanke just blogged about it, arguing there’s no need to rush.


Hopefully they’re trying to avoid the past. Bernanke surprised the markets in mid-2013 when he said the Fed might cut back on monthly bond and mortgage-backed securities purchases by $10b. The result, traders panicked and pushed the 10-year yield to nearly 3% from below 2% in four months, sparking a crisis in emerging markets.


If they mess it up this time, it 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, it isn’t tightening. Increasing rates changes the price of money in circulation, tapering reduces it.


The Fed’s Williams said last week the central bank “won’t be disruptive at all” when it starts to let the balance sheet roll off because it will cause rates to go up, which is “desirable.” How much is desirable?


But if markets don’t get the message or a gradual message isn’t gradual enough, 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 a fixed-income trader I spoke with said that may just be the reaction on the first day.


As traders will tell you, getting into a long position is easier than getting out.

* * *

We hope that this time the Fed invites the opinions of more actual traders in advance of what could be the most momentuous decision in Fed history, instead of just relying on academics and economists, especially since this could be the one event that leads to immense rewards for those bears who managed to survive the past 8 years of activist central banks pushing the stock market higher at all costs.