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The Fed is about to reveal how it could wind down its biggest policy experiment ever

  • Fed releases minutes of its last meeting Wednesday afternoon
  • The minutes are expected to show some detail of Fed discussions on how it plans to reduce its $4.5 trillion balance sheet
  • The Fed's comments on the economy, particularly inflation, will also be important because traders doubt the Fed's forecast for two more rate hikes this year

The Fed is about to tell the markets how it plans to remove itself bit by bit from the experimental program that made it a major player in the financial markets.

In Wednesday's release of minutes from the Federal Reserve's last meeting, economists expect to see some rough details of how the central bank could start the unwind of its massive $4.5 trillion balance sheet, a process it should take slowly since it could impact interest rates.

The Fed built up its balance sheet during and after the financial crisis, buying Treasury and mortgage securities to add liquidity to markets. After it ended its quantitative easing programs, the Fed continued buying securities as those holdings matured, in an effort to keep markets steady and interest rates low.

"It's an experiment the Fed is hoping they can extricate themselves from to some extent. ... They're going to try to do it in a way that's not destabilizing. That's the hope. Given the fact we've been talking about it for a while, my guess is the Fed will be successful because it's been so well advertised," said Joseph LaVorgna, chief U.S. economist at Deutsche Bank.

The unwind should drive interest rates higher, but LaVorgna said no one knows how much for sure. The Fed will also pace its program, based on the economy and the reaction to it.

"It will very much depend on financial conditions and the evolution of the forecast of how the economy is expected to evolve. What the Fed would like to do is avoid anything similar to 2013 when the taper tantrum caused significant market disruption," he said.

The Fed's QE purchases targeted longer-dated securities, and yields in 10-year and 30-year Treasurys have also been kept low by the fact that the European Central Bank and Bank of Japan went to negative yields and have their own asset-buying programs. By comparison, low U.S. yields look attractive.

The Fed's quantitative easing also led to tighter spreads and lower volatility, and helped reflate stocks and other risk markets.

"We think a shrinking Fed balance sheet, especially if not countered by sufficiently expanding central bank balance sheets elsewhere could have the opposite impact," wrote Morgan Stanley fixed income strategists in a recent note. They warned it could be unpredictable. The strategists said interest rates should rise, but when conditions are tightening, "shocks" are not as easy to absorb and high leverage becomes harder to manage.

"There are few precedents for actively tightening policy via central bank balance sheets alongside rate hikes. Hence we would caution against expecting an uneventful voyage," the Morgan Stanley strategists wrote.

Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch, said he expects the Fed to ultimately reduce its balance sheet by about $1 trillion. He said the reduction of $2 trillion is estimated to have the equivalent impact of a 0.75 increase in the yield of the 10-year Treasury note, all else being equal.

Cabana expects the Fed to be flexible with the unwind, and slow or even reverse it if the economy needed help or interest rates were rising too quickly.

The Fed has been signaling it will start the exit process at the end of the year, possibly as it pauses after two more rate hikes. So, the central bank's economic comments in Wednesday's minutes will also be important, since traders have been doubting the Fed can raise as much as it would like this year. That's because economic data have been softer than expected, particularly inflation, and the political turmoil in Washington has created some uncertainty, so comments on the economy could show how confident the Fed is in its forecast.

"If we see a majority of participants signaling the data does not signal a weakening trend, that would be instructive that the Fed is looking through its recent softening and is not deterred by it," said Cabana. If the Fed is concerned, it would raise doubts about the rate hikes and the December action on the balance sheet.

Many economists expect the Fed to hike interest rates in June and again in September, before focusing on the balance sheet at its December meeting. The market is now pricing an interest rise for June but about a 30 percent chance of a September increase.

LaVorgna said he expects the Fed to hike both in June and September, and then announce a "tapering" of its balance sheet, starting next January. In December, he expects to see the Fed give clear detailed guidance on the process.

LaVorgna said the tapering of its reinvestments could look very similar to its tapering of purchases in 2014. The Fed could reduce reinvestments by 80 percent beginning in January. Then go to 60 percent in the second quarter, 50 percent in the third quarter and 20 percent in the fourth quarter. The Fed could then allow all maturing securities to roll off its balance sheet starting in 2019.

Next year, $425 billion of the Fed's Treasurys mature, more than double this year's level. In 2019, the amount falls to $350 billion, and then drops to about $200 billion in following years.

LaVorgna said for instance, the Fed could return $21.5 billion to the market of Treasurys in the first quarter of 2018 and $8.9 billion of mortgage securities, then increase it to $46.2 billion of Treasurys in the second quarter, along with $17.8 billion of mortgage securities.

Watch: Strategist says Fed will become more pragmatic