How Will the Federal Reserve Untie its Gordian Knot?

by David Haggith, Silver Bear Cafe:

The Federal Reserve is telegraphing that it is going to begin its great unwind in September. It’s going to untie its own not untiable knot. In case you cannot untie what I just said, that’s a knot that cannot be untied. I’m writing the article to ask you to ponder this conundrum with me. Can the Fed undo its quantitative easing without undoing the vapid recovery it fashioned out of that quantitative easing?

I’m starting with the premise that the Fed is trying to talk up the reduction of its balance sheet, starting in September, because it actually wants to unwind and still hasn’t realized it cannot. That premise, of course, may be wrong. They could simply be lying, but strong historic precedence argues in favor of stupidity.

I believe the Fed WILL start to unwind, as they’ve said they will, and havoc will begin in stocks and bonds and housing and all kinds of markets as quickly as the Fed starts to do what it has long said it will do and people begin to see that it cannot do it. I have always suspected they have no end game, but they thought they would eventually unwind into a strong economy with a lot of resilience toward their unwinding. They probably even thought their recovery would build to where some gradual cooling might be necessary to avoid inflation. Their unwinding would cause that necessary cooling.

Instead, they find they have, at best, a nearly stagnant economy where borderline stagnation promises to be the best they can hope for throughout years to come, and they have almost no inflation (by their measure). So, they must now figure out how to unwind in a situation of borderline stagnation … or never unwind.

Why the knot cannot be unwound

Here is how I think everything falls apart: As soon as the Federal Reserve starts to unload assets (being mostly bonds and those nasty derivatives), they will have to unload their junk (for they sopped up a lot of junk) at a price that will entice others to buy their sludge. I would think it takes a pretty high price (interest) to get investors to buy up junk bonds and peculiarities that, at one time, were believed to carry risk of such size that only the Fed could handle it. Of course, they own a lot of US debt, too; so, they’ll probably start with the easy stuff. Rising interest on bonds will tend to draw money out of stocks, so stocks will fall unless they receive even more extraordinary propping than what we have learned about recently about the Swiss National Bank buying huge amounts of US stocks.

The rise of interest on bonds will also have the collateral effect of making all debts less sustainable at a time when the nation is extraordinarily top-heavy in debt. That will not only increase the United States’ rapidly rising deficit, but it will make Trump’s fiscal stimulus impossible (as if it were not already going to create its own interest increase that will undo itself) because the new debt for Trump’s stimulus plans will have to compete with the debt the Fed is trying to unload along with the debt the government already has to refinance.

Since the Fed used quantitative easing in order to lower interest rates (especially long-term interest rates, such as on mortgages) and to increase liquidity, I don’t see how they unwind their QE without causing interest rates to rise. In a robust economy, they might want interest to rise; but in the present flagging economy, a rise in mortgage rates will cause the latest housing bubble to collapse because the housing market already looks like it is turning.

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