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.