Fed Will Unwind the Balance Sheet at an Awkward Moment

The playbook for U.S. Treasuries hasn’t changed much since the end of the Great Recession. First, traders come into a new year with a bearish bias, pushing up yields on the expectation that the conundrum of extremely low long-term rates will finally unwind as the economic recovery pushes on. Then, there’s a gradual capitulation as the global demand for Treasuries and disinflationary forces persist, driving yields lower in defiance of the Federal Reserve’s aggressiveness.

Things are about to change in at least one key respect -- the Fed will finally start unwinding its gargantuan $4.5 trillion pile of Treasury and mortgage securities in just a few months, convinced that the crisis-averting quantitative easing measure is no longer needed. The withdrawal of central bank support for the Treasury market will come at an inopportune time for the debt managers at the Treasury Department because of the outlook for rapidly growing budget deficits. That combination will put massive upward pressure on Treasury yields as the government ramps up bond sales. It won’t help that the European Central Bank is also starting to talk about pulling back.