The spin masters of Wall Street are starting to talk about the fed exiting their strategy of quantitative easing to infinity. It is time to discuss the exit strategy of the fed from its bond buying expansion. Before the crisis began, the Fed held roughly 800 million dollars of US debt. Today, the Fed is well over 3 trillion and growing. At some point the fed buying will have to pullback and eventually stop. Many people are afraid of the effect this will have on the equity and fixed income markets.
Our take is two-fold, as each fed action will have different effects. First, when the Fed pulls back or stops buying, we will most likely see both the equity and bond markets sell down in price. The severity will depend on whether the fed pulls back or stops. Then second part is: What does the Fed do with trillions of dollars in debt? Depending on the Fed’s actions, selling out of their positions could cause a spike in interest rates. The repercussions would be that borrowing cost will go up and holding a bond will incur a paper loss as the bond market re-prices. There is no easy way out and Granite Group believes the best way for the Fed to exit is to do it slowly over time. For fixed income holders, a shorter duration and then reinvesting bonds as they mature is a practical solution. There will be some dislocations when the Fed exits these programs and we are not suggesting that yields will go back to 5% levels anytime soon, nor are we suggesting a 20% correction in the S&P. We can only hope that if Yellen (or whoever else replaces Bernanke), takes his/her time and does it the best way with the least amount of pain to the markets. What is certain is that they will have a hard balancing act.
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