Diminishing Effect of QE: Increasing Exit Risk

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.

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.

If you own bonds ( iShares Barclays TIPS Bond ETF ( TIP) , iShares Barclays 20+ Year Treasury Bond ETF ( TLT) , iShares S&P National Municipal Bond ETF ( MUB) , iShares iBoxx Investment Grade Corporate Bond ETF ( LQD) ), and who doesn't nowadays, be ready to jump ship and hope you're not late.

I dare not predict when the bubble will go bust. It really could last quite a few years, as in Japan; on the other hand, judging from the zero marginal effect of QE4 and especially if you are optimistic on U.S. economic recovery, we could be close to the turning point. Either way I'd rather stay away from the rat race early and stay with SPDR Gold ETF ( GLD).

At the time of publication the author was long gold.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.