How Will The Market Absorb Trillions Of US Treasury Bonds to Replace The Feds Balance Sheet Wind Down?

First, the facts:

At Powell's Nov 28th 2017 testimony to Congress, Powell said that as the Fed allows its 4 trillion dollar balance sheet to wind down, the US Treasury would issue new bonds to the market to replace them (so, technically, US notional debt will neither increase nor decrease as a result of QE).

Recall that QE is a sterile operation (this is why we don't have hyper-inflation).  What does that mean?  Sterile means that the US public debt will neither increase or decrease as a result of QE, and neither will the money supply.  Another way to say this is that QE is a cash neutral operation.  Where cash is pushed into the system at one point, it must be drained someplace else (in our case, the Fed offers interest to banks to store their cash at the Fed...mostly with IOER - interest on excess reserves..and all the banks have indeed been doing this).  This is also why banks are not over-excited to lend you money...they get risk free money to deposit their cash at the Fed.  QE simply took US debt off the markets balance sheet, and placed onto the Fed's (yes, the Fed printed digital fiat currency to make this happen...but the unwind will reverse  this "money" creation).  So, the Fed bought 10yr notes with funny money..will hold them to maturity...and then when those 10yr notes mature, the US Treasury will auction new bonds into the market to repay the Fed, making the funny money disapear like magic.  This whole process together "sterilizes" the Feds money printing...but in the meatime, the market pushed that money into other assets (mostly stocks).

Here is the simplified flow of money:
Fed QE --> bond market --> stock market --> bank accounts --> Fed accounts(IOER)

Such that total dollars in circulation didn't change much...they ended up back at the Fed (with a nice uptick in asset prices as an inbetween step).
There was a nice side effect to this...while the Fed holds a large balance sheet...the US Treasury doesn't have to pay interest on its debt (because the Fed remits all its profits back to the Treasury...and interest income is considered profit).  When the Fed winds down its balance sheet, the Treasury will have to start paying interest on that debt again.

The interesting question is thus:  When the US Treasury tries to sell 1-2 Trillion dollars of long term debt back into the market...what happens to interest rates and the stock market?  Recall #1 that after the Trump election, 10 year interest rates moved from 1.80% to now 2.40% (expectation of Trump borrowing lots of long term money to finance his infrastructure and deregulation projects).  But that hasn't even happend yet (analysis of the Republican tax plan cost estimates an additional 1 Trillion US long term debt).  Recall #2 that the Fed is currently holding a lot of that debt...which minimized the need to liquidate bad long positions in the post Trump bond market selloff.  US Treasury debt is "high quality" and so the market will buy it...but at what price?  This is the big question.  Will the market sell stocks to make room to buy up all this new debt (reverse QE)?  Does this cause the next stock market crash?  (hint hint - probably)

 

The piper must be paid eventualy.  However, just like in Cyprus...the banks will have a heads up...and their assets will be safe.  What will happen to yours?

GovtTrader