July 31, 2017

Leading up to 2007 – before the Federal Reserve’s Quantitative Easing program and Zero Interest Rate Policy, the Fed held about $800 billion in its portfolio, or “balance sheet.”

Today, the Fed has about $4.5 trillion on the balance sheet, much of which is government debt and mortgage-backed securities purchased years ago to save us from crisis. Well, at its last meeting the central bank announced it would decrease its balance sheet

It’s a tricky situation because the Fed has never held this much debt. And now it must, somehow, return to more traditional levels of debt. If the “unwind” goes wrong, the pain could be profound. Interest rates could rise sharply. The stock markets could be manic. And it could ultimately lead to a recession. The Fed has been rolling over bonds on the balance sheet as they mature, meaning the proceeds are used to buy more bonds. But that practice will end, which could reduce overall bond demand, causing yields to rise. The sell-off will be $10 billion per month, starting later in 2017. It will rise to $50 billion per month in 2019.

Nobody knows how it’s going to unfold. One possibility is the Great Unwind could lead to an interest rate environment in which short-term debt has higher yields than long-term debt of the same quality. That’s bad news, as it’s a reliable predictor of recession. It’s called an inverted yield curve and it looks like this:

Typically, debt follows a pattern in which longer-held debt yields more than short-term debt:

The last two times we had an inverted yield curve was right before 2000, when the NASDAQ dropped 80 percent, and 2006, when we saw the housing bubble start to burst. Is another crisis coming? Nobody knows.