DAVID ROSENBERG: Everyone's scared of the wrong thing when it comes to the Fed's plan for its $4.5 trillion balance sheet

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July 7, 2017 11:18 AM

The Fed built up a $4.5 trillion fortress by buying up government debt as it dealt with the worst crisis since the Great Depression. Unwinding this could hurt.

David Rosenberg.

The Federal Reserve built up a $4.5 trillion fortress by buying up government debt as it dealt with the worst crisis since the Great Depression. It did this to suppress interest rates.

Now that the US economy is on a stronger footing and US banks are in relatively good shape, the Fed is left with the task of unwinding all this. The minutes from the June Federal Open Market Committee meeting indicate it could begin in earnest in September, Deutsche Bank economists Brett Ryan and Matthew Luzzetti wrote in a note to clients on Wednesday.

But of course, as widely forecast as it is, worries about the potential impact of this have pushed Treasury yields — and therefore interest rates in many corners of the US economy — higher since mid-June. The benchmark 10-year yield has rallied from 2.12% on June 14 to 2.38% now. Wall Street is expecting the 10-year to hit 2.90% in the next 12 months as the Fed lets expiring Treasurys run off its balance sheet.

When the unwind happens, however, it could catch traders in both the bond and stock markets off guard, warns Gluskin Sheff economist David Rosenberg. Here's Rosenberg referring to the Fed's various bond-buying programs, dubbed quantitative easing, or QE, and their impact on stocks and bonds (emphasis ours):

As for how it all plays out, Rosenberg sees three paths.

Regardless of the outcome, Rosenberg warns: "The economy may end up being spared, but what we do know about these three prior episodes, in fact, what we know about all thirteen periods of Fed tightening in the post-WWII era, is that these cycles don't end without the financial excess of the bull market condition becoming exposed, and then expunged."

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