The Fed and the pain of unwinding: James Saft

February 20, 2013

Feb 20 (Reuters) – The Federal Reserve minutes show real
concern and debate over how big its balance sheet can grow and
for how long it can stay that way.

You should share that concern, because a Fed which is buying
fewer bonds, or even, heaven forfend, selling some, is a central
bank creating, once again, the needed conditions for deflating
the bubbles they just blew.

“Several” members of the Federal Open Market Committee
argued that they should be prepared to vary the amount of bond
purchases, now $85 billion per month. “A number,” a form of
words meaning less than “several,” said the costs and risks of
asset buys might indicate that the Fed should taper or end them
before it has reached its avowed employment goal.

Yet another “several” advocated against an early decrease,
while “a few” offered the alternative of just pledging to hold
on to bonds longer as a kind of palliative or supplement.

Something there for everyone, but the upshot is that the
discussion over how and when the great bond-buying experiment
might be unwound is getting more serious, which, for risk asset
investors, is a little like being told they will have to move
out of their parents’ basement and fend for themselves.

After a brief confused rally, equities headed lower, with
the S&P 500 falling more than 1.2 percent, while Treasury
bonds rallied. That argues that investors view QE3
as stimulus and that the big problem if it ends won’t be who
will buy bonds but what will spur growth. On that view when QE
tapers or ends it removes a source of funds for the stock market
but investors worried about growth will keep buying Treasuries.

If the equities fall extends and lengthens in time, look for
Fed Chairman Bernanke or others to give the impression that the
solid center of the FOMC is not close to taking action.

The truth is that all risk markets should worry about the
Fed’s plan to unwind its $3 trillion portfolio of bonds, and
that includes Treasuries, which as a market dominated by a
single buyer, are by definition a risky asset.

“If it is true that Fed tightening cycles have never ended
without either a recession, a financial disaster or some
combination of the two, then it is equally true that a prolonged
and intense Fed easing phase has never failed to usher in an era
of exuberance followed by a bubble somewhere,” Gluskin Sheff
strategist David Rosenberg wrote in a note before the minutes
were released.


Most notably the over-reaction to the Long-Term Capital
Management blow-up in 1998 meant the Fed kept rates far too low
while the Internet mania boomed, leading to a far more
destructive bust when rates were finally raised in 1999 and
2000. And of course the disappointing recovery in the early part
of the last decade led the Fed again to keep rates exceptionally
low – 1 percent – even into mid-2004 as the real estate bubble
was building and real and nominal growth were rising reasonably.

It is hard to argue that the cumulative effect of the Fed’s
easing this go round is less than either of those episodes, and
so you have to wonder if the reaction to the Fed’s tightening
will rival 2000 or 2008. And be in no doubt, a Fed selling bonds
is a Fed which is tightening, even if it is still far away from
raising rates.

Federal Reserve Board Governor Jeremy Stein maintained in
his speech two weeks ago that parts of the more exotic sections
of the bond market like high-yield were showing signs of
bubble-like activity, and it is clear that those markets have
benefited by a reaching for yield supported by Fed bond buying.
Former owners of Treasuries sold to the Fed find little to like
in super-low rates and some of that money finds itself further
along the risk spectrum. The day the market believes the Fed is
finished is the day that reverses.

Similarly, equities are hugely supported by QE, and will be
similarly challenged by its end, whenever that comes.

Finally, who is going to want to buy long-term Treasuries
when the Fed is selling? You only will if you think they are
doing so way too soon.

There is no easy way for the Fed to unwind its balance
sheet, which is maybe the best reason not to take the debate
depicted in the minutes too seriously.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at and find more columns at

(Editing by James Dalgleish)

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