Right now, everyone wants to know how much more the Fed’s going to hike, what the terminal rate will be (the highest level that fed funds get to), and how long might they keep rates elevated.

But that’s looking in the wrong direction. We know the answers already.

Rate hikes aren’t as important as they’ve been simply because the Fed’s done frontloading and future hikes will be smaller in magnitude, and markets know that. The terminal rate will probably be 5%, because that’s what the Fed just said they want it to be, so that’s already baked in. We also know they’re committed to keeping rates up until inflation gets to around the 2% annual goal the Fed has set in stone, for now at least.

The real damage you need to get ready for is from quantitative tightening (QT), the reduction of the Fed’s $8.6 trillion balance sheet. They’re letting billions of dollars in maturing assets “runoff” the balance sheet, meaning that they won’t be replaced.

Problem is, someone’s going to have to buy them. And unlike in prior years, when the world lined up to buy Treasury bills, notes, bonds, and mortgage-backed securities (MBS) from the U.S. government, there aren’t going to be any takers this time.

That’s why QT is going to be the straw that breaks the camel’s back, for both bonds and stocks.

Let me show you what’s been happening, what the damage is going to look like, and the very best way you can set yourself up to come out ahead as things shake out.

Why QT Is Such a Poison Pill for Markets Next Year
QT, for now, isn’t about the Fed actually selling Treasury bills, notes, bonds, or agency MBS out of their balance sheet. It’s about allowing maturing assets to “runoff” the balance sheet, like I said.

All runoff means is that as assets mature and come out of the Fed’s balance sheet they won’t be replaced. So, no more Treasury or MBS buying by the Fed. No more “buyer of first resort” anymore.

Starting in June through August this year, the Fed let $30 billion in Treasuries and $17.5 billion in MBS, per month, runoff their balance sheet. In September they raised the “cap,” how much they assigned per month to let runoff, to $60 billion a month for Treasuries and $35 billion a month for MBS.

Now here’s the problem.

That’s $95 billion a month worth of Treasuries and MBS that other buyers are going to have to step up and buy. Not because the Fed’s selling them and looking for buyers – they’re not selling anything yet, they’re simply letting them mature.

But the U.S. Treasury must still issue new debt as well as rollover all its maturing debt, including all the Fed’s runoff debt, because they don’t have the principal to pay off all that maturing debt. They don’t have the principal to pay off any maturing debt for that matter, so they have to issue more debt to pay off the principal they owe, and issue even more debt to pay for the country’s increasing expenditures.

So who’s going to buy that debt? The Fed won’t, not while they’re paring everything back.

Foreign countries used to be a reliable buyer, but right now? The Russians won’t, for obvious reasons. Japan is raising rates for the first time in decades and can’t even afford to buy more Treasuries. The Chinese? Forget it – they’re embroiled in their own scheme to knock the U.S. dollar out of its status as the world’s reserve currency in favor of their own, the yuan.

That brings us to the Saudis, maybe one of the most reliable buyers of Treasuries thanks to the petrodollar regime established in 1945. The very short version – we sell the Saudis military equipment, they guarantee that the U.S. dollar is the de facto currency for global oil export trades, we we allow OPEC members to invest in our markets, and surplus oil proceeds are used to purchase U.S. Treasury debt.

Except the Saudis just entered an agreement with China to sell oil to the Chinese for yuan instead of dollars, a warning shot across the bow of the United States that, at long last, they’re seeking to wean themselves off this decades-long arrangement.

Luckily for the U.S., higher rates available on Treasuries has brought in domestic buyers by the droves, including individuals and money managers and all kinds of institutions including pension funds and insurance companies. But they’ll soon have their fill and won’t be able to absorb the trillions of dollars of new debt soon to be issued by the Treasury.

And the primary dealers, the giant banks that have to buy Treasury issues, have been hamstrung by how much they can buy on account of Dodd-Frank rules that require them to reserve against Treasuries they buy. Given that they’re already constrained by reserve requirements and balance sheet limitations, they won’t be able to pick up the slack.

Not only that, things are worse for MBS.

As interest rates rise, the “duration” or maturity of pools of mortgages lengthens, meaning as an asset their maturity is extended. That’s because in a rising rate environment, there isn’t a lot of refinancing going on, which would mean old mortgages are being paid off. Instead, people are holding onto their mortgages with their lower rates, and that makes the life of those loans longer.

Everyone knows that longer maturity bonds get hit harder when rates rise. Now, with the Fed’s MBS holdings (which are $2.7 trillion worth) becoming longer dated assets, their price gets hit harder with rising rates. That means the Fed’s losing money on those balance sheet assets.

And as if that’s not bad enough, since those balance sheet assets won’t be maturing as expected, they won’t runoff as part of their $35 billion a month cap. So they’ll have to sell MBS to get them off their balance sheet.

Who’s going to buy them? Not the investors already sitting on MBS portfolios taking hits, that’s for sure.

So, this is the problem. Now, here’s a solution.

Here’s the Best Way to Prepare for QT Damage
What’s going to happen is interest rates are going to rise, irrespective of what the Fed’s already doing, or more likely because of what the Fed’s doing.

And as the Treasury raises rates on new issues to attract buyers, and as pools of MBS fall in price, it’s going to send shockwaves through the bond market and the stock market.

That’s why buying and holding a Treasury bond inverse ETF like ProShares UltraShort 20+ Year Treasury (TBT) is a good idea, especially now that TBT’s come down and is ripe for buying down here.

The worse things get, the better the return here will be.

— Shah Gilani

Source: Total Wealth