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.
Treasury budget funding would be much more expensive overnight, quite possibly causing a real downgrade -- real in the sense that it will compound the market panic, unlike the recent downgrade when market access was not impeded at all. Many corporations and municipalities would lose market access to issue or roll debt. The housing market would come to a screeching halt. Then people would wish the Fed had never done any of the funny QE business.
But this will not happen, you say. This view implies that the Fed will be politically forced to be late in exit, which I warned shortly after QE1. When the economy finally recovers, and leverage rises (and this time not necessarily driven by banks and derivatives, but rather by "real companies" and consumers), the Fed will be hand-tied until the damage of inflation becomes unbearable, e.g., seniors with hatchets on the street and an American Hitler rises up to seize the moment. In addition, assuming the dollar is still a major reserve currency by then, this would cause a worldwide inflation tsunami, which would then cause severe international tension that may finally end the dollar hegemony that many countries have been preparing for.
Either way, we are screwed. It's a painful dilemma, and the severity of pain is directly related to magnitude of balance sheet that needs to be shrunk. I doubt even Volcker would be able to deal with a problem this big.Just to stay away from the Dec. 21 crowd, let me say that I don't think the QE end game will be quite so ugly. We should be able to end it before total mayhem, hopefully. But it will be very painful. Anyone unlucky enough to be the Fed chairman is doomed to suffer huge amount of pressure, work extremely hard, and go down history hated by everybody. Unfortunately, this will not be Bernanke. No fair.