The Fed’s Shrinkage Problem

Gerd Altmann/Pixabay

Commentary

Imagine you’re at the helm of the Queen Mary….

You’re bringing your cruise ship into port when over the radio comes the harbor master telling you they’re having some docking issues so you’ll need to parallel park your ship between the Maiden of the Seas and the Ocean Dreamer. You’ll see the spot up on your right.

If the thought of parallel parking a cruise ship sounds a little absurd, it should.

The sheer size of those ships and their lack of maneuverability makes a precision move like parallel parking impossible. Who would try such a thing? (Think of the wreckage!)

Apparently, the Fed would.

They’re facing a task that carries the same level of challenge (or level of absurdity, if you prefer) as squeezing a 900-foot cruise ship into a 950-foot parking space.

And one that, depending on how they execute it, could leave a trail of financial wreckage in its wake—and shift investing paradigms into a very “risk-off” asset rotation.

Maneuvering Big Stuff

Everyone knows the Fed has been printing money via its QE program since the financial crisis of 2008. But for the past two years, they’ve put it into overdrive.

What few people think about is what happens to all the assets they buy. For better or worse, they end up on the Fed’s balance sheet.

“So what?” you might ask.

Ideally, the Fed should only hold as many securities as it needs to implement its monetary policy. Carrying more indicates economic and financial trouble.

Prior to the 2008 housing meltdown, they only held about $900 billion.

Today those assets on their balance sheet are adding up to nearly $9 trillion. They’ve 10x-ed it in just under 15 years. That’s a Queen Mary-sized load of bonds.

When Assets Become Liabilities

And now there has been talk at the Fed about “discussing plans” to shrink their asset position (selling assets they own). They basically only have two options. And none of them bode particularly well for the bond market.

One, they could start dumping them in the secondary market. But doing that with $ 9 trillion in bonds would be like...

Well, in 1958 a massive rockslide in Lituya Bay off the coast of Alaska generated a megatsunami that sent a 1,720 foot wave across the bay obliterating the tree line and all the vegetation. Some areas of the bay are still recovering over 60 years later.

It’d be kind of like that. (So that idea’s out.)

Plan B would be to let those assets “run off”—just mature without purchasing any more. This would further drain demand (assuming the QE taper is already complete) from the fixed income markets. That means it would have a similar, but way more subtle, effect on the markets.

Or they could come up with something like the Fed is wont to do when they have no other options. (Think of inventing “quantitative easing” when they had finally hammered interest rates to zero.) I really have no idea what that might be—but they are a creative bunch.

The bottom line is, no matter what they do, the treasury market is going to come under pressure. It could be a lot or it could be a little, but either way it means looking at higher interest rates at the long end of the yield curve. (Which poses yet another problem by sharply increasing borrowing costs for the Treasury.)

Last Friday the 10-year Treasury yield rallied to around 1.79 percent—a level the market hasn’t seen since January of 2020. (Rampant bond buying by the Fed had kept rates under pressure.)

I think it’s pretty clear bonds are bracing for the worst. And keeping an eye on the yield curve would be a smart thing for investors to do right now.

Whether the Fed likes it or not, they have a big boat to park... and if they miss their mark, the financial carnage will be epic.