Most market observers expect the end of the Fed's QE asset-purchasing program to immediately result in a sharp sell-off in bonds and higher interest rates.
This is expected to hit the mortgage-backed securities (MBS) market, where the Fed has been very active, quite hard.
As part of a policy to communicate more openly with the markets, Chairman Ben Bernanke and the Fed have been regularly launching QE exit strategy trial balloons into the market to see how quickly they get shot down.
The latest exit strategy that has been gaining traction is the idea of "tapering" QE asset purchases so that there isn't a sudden halt to supply of money flowing from the Fed into the Treasury and MBS markets. The markets seem to be pretty sanguine about the tapering idea, although there has been no specific suggestion on timing.
Instead, the markets have been concentrating on how the Fed will get rid of all of the assets it has accumulated on its balance sheet during the QE program.
Will the Fed's Bloated Balance Sheet Stoke Inflation?
Ethan Harris, co-head of global economics research at Bank of America Corp. (NYSE: BAC) in New York, told Bloomberg News he is concerned the Fed will "in a robotic fashion, dump assets" on the market, causing interest rates to climb rapidly.
This is highly unlikely.
Bernanke said in his Feb. 27 testimony to the House Financial Services Committee that the Fed could simply keep the assets on its balance sheet and just let them mature. In this way, the markets would not be disturbed by Fed selling and the Fed would not have to realize losses on its MBS and Treasury holdings.
Market participants worry that, even after QE is finished, unless the Fed sells off the excess assets it has accumulated through QE, it could cause inflation.
"If the Fed doesn't withdraw quickly enough, there's a risk of overshooting," Dean Maki, chief U.S. economist at Barclays Plc (NYSE: BCS), told Bloomberg.
"If the Fed gets rates back to a typical level and the economy is back to what's regarded as normal, does having an expanded balance sheet have a notable effect on the economy, on asset markets, even once rates are normalized? We haven't really had that situation in the U.S. before."
The Fed has made it very clear that it will keep its target overnight rate at between zero and 0.25% for as long as the unemployment rate remains above 6.5% and inflation remains below 3%. If the zero-interest-rate policy remains in effect, then the velocity of money will continue to decline and inflation is likely to remain in check.
Fears about the Fed's balance sheet causing inflation assume that QE is actually working in the first place and there is little evidence that this is the case.
Market Reaction to the End of QE
Many market participants wonder how the Fed thinks it can control the market's reaction to any announcement of the end of QE.
Even if the Fed "tapers" down its asset purchases, traders anticipate that "the market will flip on them [the Fed] immediately" and that there will be a swift reversal of bond prices.
Many of the biggest bond funds are hedging their long bond positions against the day QE ends.
"We don't subscribe to the view that once the fire starts, we'll be able to outrun everybody through the door," Stephen Kane, managing director for U.S. fixed income at TCW in Los Angeles, told The Wall Street Journal. "Rates could be up 50 basis points before your traders can get all the sell orders through."
Everyone understands QE has to end one day. The problem is that the market will probably overreact no matter how much explaining the Fed does.
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It will be hard if and when the easing ends