UTSanDiego.com

Diminishing Effect of QE: Increasing Exit Risk

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NEW YORK ( TheStreet) -- The diminishing marginal effect of QE's has been well documented on the blogosphere. Yet it was still a bit surprising to me to see the virtually non-existent effect of QE4. The market had completely priced in the expectation of QE4 days in advance, managed to feign mild excitement for an hour and half, and then proceeded to go back to fiscal cliff afterwards.

This is quite extraordinary considering that QE4 did break some new ground in the history of central bank monetary policy, even after the historical perpetuity of QE3, by using unemployment rate as a benchmark.

The apathy to such a heroic adventure speaks louder than gushing excitement that I suspect had been expected by many. Yet I haven't seen any convincing explanation as to why the diminishing effect occurs, though there's plenty of mentioning of the fact and the ensuing cynicism.

I have a hypothesis to offer. The market is pricing in the increasing exit risk as the Fed balance sheet expands.

The Fed balance sheet will shrink one way or another. If the Fed takes no action, assets will mature and it is effective tightening; but this would take a long time.

Although I believe the U.S. is well underway following Japan's lost decades, at some point the demographics will revert to a healthier structure and the slump will end; at that point companies will start investing in future expansion, private sector leverage will go back up, and the Fed must withdraw liquidity from the system. The tricky part is always when to withdraw and how fast. And it gets trickier as the balance sheet size increases.

Currently, Fed balance sheet stands at about $3 trillion. Assuming the $85 billion/month QE4 continues until the end of 2014, total balance sheet will be about $5 trillion by then. How fast can the Fed shrink it? According to SIFMA data, for 2012 the daily trading volume in treasuries is $521 billion, and agency MBS $286 billion. A persistent seller accounting for 10% of the daily volume would cause panic after at most a few days. Meanwhile, 1% (persistently) might be achievable by very experienced hands, with a lot of tricks to evade detection for a week or two. At $5 billion a day on average, it'd take the Fed two years to shrink the balance sheet by half.

Of course, the Fed's open market action will be open. Massive front-running selling would commence immediately when the market senses the first sign of Fed shrinking. As a result, treasury and MBS yields would rapidly rise. So would corporate/muni bond yields, swap rates, and mortgage rates, by extension. All the pension funds and mutual funds loaded neck-deep in bonds would cry out in unison.