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Fed's trimming of $4.5 trillion balance sheet could have some 'hiccups'

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Fed's trimming of $4.5 trillion balance sheet could have some 'hiccups'

If the Federal Reserve has its way, the markets will barely budge as it gradually winds down much of its roughly $4.5 trillion balance sheet, which ballooned as the central bank fought off the financial crisis.

Fed officials say they are going at a slow enough pace to avert major risks in the markets and that their clear communication of the plan should also help. But others said it is far from clear whether issues might pop up, because the situation is unprecedented.

"I think there is ample opportunity for there to be hiccups," Baird investment strategist William Delwiche said. "I wouldn't say that I'm expecting there to be a problem, but … I think there is certainly a chance that it's not necessarily going to be smooth sailing."

The reductions mark a rollback of the quantitative easing, or QE, program in which the Fed bought up Treasurys and mortgage-backed securities in an effort to bring down long-term interest rates and encourage borrowing. The Fed has begun trimming up to $10 billion a month, and the cap for those reductions will rise to $20 billion next month and will keep going up until reaching a $50 billion monthly limit in October 2018.

Peter Boockvar, chief market analyst at The Lindsey Group, said the yearslong easing of monetary policy drove up the values of stocks and a wide range of other overvalued assets. And now, he said, the Fed is "taking away the punch bowl."

"I think it's a very big deal," he said. "I think markets are way too complacent about the impact. I think they forget how excited they got when we had QE infinity."

Next year, as the Fed's monthly reductions start going up, the Fed will let up to $420 billion roll off its balance sheet.

How far the Fed will go has not been decided, though its balance sheet will almost certainly end up higher than the roughly $870 billion it had in August 2007, before the recession started. Fed chair nominee Jerome Powell said at his confirmation hearing that the amount may end up at $2.5 trillion to $3 trillion, telling senators that it "will be no larger" than needed.

Delwiche said that is likely appropriate, given that the Fed's balance sheet before the recession was not large compared to the overall U.S. economy.

The Fed is so far leading the way among major central banks in tightening monetary policy. The European Central Bank will begin halving its asset purchases in January, while the Bank of Japan is showing little sign of stopping its stimulus, and its balance sheet is approaching the size of the country's GDP.

But the Fed will not be highlighting its reductions much in the coming months. The program, for example, was not mentioned in the latest statement from the Federal Open Market Committee. Fed Chair Janet Yellen said at her Dec. 13 news conference that that is because it is not the Fed's primary way of conducting monetary policy.

Kathy Jones, chief fixed income strategist at Charles Schwab, said the Fed's monthly caps on reductions should make it a "smooth" process.

Still, she cautioned that markets have not fully priced in the effects of the Fed's tightening both the balance sheet roll-off and increases in short-term rates — likely pushing up yields for 10-year Treasurys in the coming months.

"I think the biggest question is: Is the market really prepared for this kind of tightening?" she said. "We haven't really done it this way before."