The Fed's new 'diet' will likely cause some 'hunger pains' in the bond market

  • The Federal Reserve just announced it is going to start paring down its massive $4.6 trillion balance sheet.
  • The bond market had a spastic reaction, with Treasury yields spiking.
  • There could be more "hunger pains" to come with this new Fed diet — maybe even some dizzy spells!

The obese Federal Reserve is finally on a diet.

Federal Reserve Chair Janet Yellen announced on Wednesday a highly anticipated move to start reducing the central bank's gigantic $4.6 trillion balance sheet. The bond market expressed immediate concern. Buyers vanished and Treasury yields spiked — specifically on the short end of the yield curve.

The spastic reaction in Treasurys was also due to the unexpected revelation that the majority of the Fed anticipates an additional rate hike this December.

On the other hand, U.S. equities hardly budged from their all-time highs subsequent to this historic Fed announcement and the Dow Jones actually ended up higher, producing its 48 thnew high for 2017.

The Fed's balance sheet has put on an enormous amount of size since the financial crisis (nearly $4 trillion). Investors are now concerned with how it will do on its diet as this may cause more than just the normal "hunger pains" associated with trimming a few pounds. As someone who knows how to swell up, I also know the tremendous challenges that are associated with taking off the new found love… Under Lou Holtz at Notre Dame, I had to put on nearly 70 pounds to compete on the football field. Like any process of trimming some size or "dieting," there are challenging moments that appear along that bumpy road. If we recall the market reaction, a.k.a. the "taper tantrum," in 2013 when the Fed initially talked about reducing its balance sheet, markets instantaneously shouted as that was unequivocally not a welcomed event. However, I believe it is different this time as the Fed has had many additional years to fatten up investors for this ensuing starvation.

What the scholars at the Fed have studied and prepared for in this balance-sheet reduction process may vastly differ from the reaction of real-life investors filled with a wide range of emotions. The 2-year note's yield spiked on Yellen's Federal Open Market Committee message and surpassed levels of 1.41 percent that we have not seen since pre-crisis 2008.

This is where the problem with the Fed's "diet" gets complicated … quickly.

"The Fed's balance sheet has put on an enormous amount of size since the financial crisis (nearly $4 trillion). Investors are now concerned with how it will do on its diet as this may cause more than just the normal 'hunger pains' associated with trimming a few pounds."

Risk happens fast and this could cause sellers to come out of hibernation across a variety of asset classes, not just Treasurys. Their painstakingly slow plan to reduce Treasury and MBS holdings by an initial $10 billion per month (starting in October) will continue to delay the very necessary repricing in domestic equities which have been the vast winner in all of the Fed's quantitative easing efforts. An inverted yield curve certainly is a recipe for a recession but, that does not seem likely near term for the U.S. Treasury yield curve.

The Treasury market will most likely endure some "hunger pains" but, it also may incur some serious dizzy spells between now and the end of the year. As the Fed desperately attempts to move the U.S. dollar index higher, I believe they will continue their hawkish rhetoric this fall.

The 10-year note will most likely float back and test its previous resistance of 2.60 percent, while U.S. stocks will likely be a victim of circumstance and also come under selling pressure. An S&P500 level of 2350 (about 6 percent lower from here) is an attractive area for money managers sitting heavily in cash to consider starting initial strategic deployment. The Fed is betting on the fact that, in the event U.S. equities get even uglier, buyers will resurface in Treasurys to stop the rising yields and their scholastic balance sheet "diet" will be stabilized and be able to continue on its unprecedented course.

As Tom Brady just revealed in his new book "The TB12 Method," drink a lot of water on this new Fed diet!

Commentary by Jeff Kilburg, the founder and CEO of KKM Financial, an alternative-investments firm based in Chicago. Follow him on Twitter @jeffkilburg.

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