Nomura's Koo on How the Fed Withdraws QE

From Business Insider:

RICHARD KOO: The Fed Is Going To Need The Treasury's Help When It Unwinds QE

Perhaps the biggest market-moving event that seems like an inevitability to market participants in the coming years is the Federal Reserve's exit from quantitative easing (QE), the bond-buying policy it has employed since the financial crisis, in the process growing its balance sheet to over $3 trillion in an attempt to stimulate the U.S. economy....

... "The surge in the 10-year yield came on the mere mention that the Fed might reduce its purchases of bonds," writes Nomura chief economist Richard Koo in a note. "If the central bank were to actually begin selling the securities it has accumulated, rates would probably react much more violently. Making matters worse is the fact that bank reserves injected into the system under QE already amount to 17.8 times the statutory reserves needed to sustain the US money supply. In other words, the Fed has a long way to go." The trillions of dollars worth of bonds accumulated on the Fed's balance sheet over the past several years thus put the central bank in a tricky spot.

Koo argues that the Federal Reserve will probably need the Treasury's help to pull off the normalization of its balance sheet: 

Treasury’s cooperation should be enlisted in ending QE

The next question is how to mop up the excess reserves that now amount to 17.8 times statutory reserves in the US. Given the size of the problem, I think any answer will have to involve the Treasury Department. 

A substantial portion of the funds supplied by the Fed were provided via the purchase of long-term Treasury securities. This means the securities the central bank has to sell as it winds down QE will consist largely of long-term bonds. 

But if the Fed begins selling long-term Treasurys at a time when the private sector has completed its balance sheet repairs and is starting to borrow money again, the result will almost certainly be a steep rise in interest rates that could stop the long-awaited economic recovery in its tracks. 

Fed should first shift portfolio from long-term to short-term bonds

When the BOJ ended its first experiment with QE in 2006, banks held deposits with the central bank equal to seven times statutory reserves. But since all of these funds had been supplied via the money market, the impact on long-term interest rates when the funds were absorbed (again via the money market) was limited. The 10-year JGB yield rose about 40bp when the removal of QE was announced but returned to its previous level within a few months....MORE