The Fed Has a $4.5 Trillion Problem. Could It Become Yours?

If you follow economic news even tangentially, or watched Fed Chair Janet Yellen's testimony before Congress this week, you've likely heard jargon about the Fed's plan to "unwind its balance sheet" later this year.

Here's what that actually means: In the wake of the financial crisis and deep recession that followed, the Federal Reserve bought $4.5 trillion worth of intermediate- and long-term bonds, in an unprecedented attempt to shore up the economy by making it cheaper to borrow -- for everyone from the federal government to companies to would-be homeowners. (To put that in context, it's roughly equal to the amount Americans had invested in their 401(k)s at the end of last year.)

Now, nearly a decade later, the Fed is moving to trim back on those investments. That could cause challenges both for the markets and for you.

The first thing to know about the Fed's challenge is that it's a good one to have -- because it suggests that the Fed's decision makers see the economy as healthy again. But even if it's good overall, the plan still carries risks, if only because no one know exactly how investors might react. After all, trying to sell a bond portfolio that big could easily flood the market, causing chaos. Imagine what would happen to stock prices if everyone in America decided to cash out their 401(k)s.

"We've never had unwinding like this before. Obviously that should say something to you about the risk that might mean, because we've never lived with it before," said J.P. Morgan Chief Executive Jamie Dimon at a conference earlier this week. "It could be a little more disruptive than people think."

To minimize its impact on the market, the Fed plans to avoid actually selling the bonds it still holds. Rather, it's just going to let the bonds "run off" by slowing, and perhaps ultimately halting, its efforts to re-invest money it receives from maturing bonds in new ones. Just how will this process go? While the Fed hasn't said what the schedule will be, one Schwab analyst recently estimated that the Fed might shed $1.5 trillion of bonds over five years -- and projected an action of that magnitude would ultimately add 0.42 percentage points to 10-year Treasury yields, which currently stand at 2.35%.

But that's just one guess.

The upshot is that if you have pretty much any stock or bond investments, or you own a home -- whose mortgage and value are tied to interest rates -- these market disruptions could have an impact on your money.

Here are a few of the ways you could feel the ripple effects.

In Your Bond Portfolio

The Fed's decision to scale back its bond portfolio should have one direct effect: All other things being equal, it should pull up long-term interest rates. Whenever a buyer that big withdraws from the market, other buyers face less competition, and can demand better terms -- that is, higher rates of interest -- from the pool of sellers (in effect, borrowers).

In the long run, that's actually good news for many individual investors. Higher long-term interest rates means more annual income for, say, retirees who are trying to live off the earnings of a bond portfolio.

In the short run, however, it may be a different story. When it comes to bonds, rising interest rates also mean falling prices, because there's less demand overall. Whether you own individual bonds or bond funds, you may see that part of your portfolio take a tumble.

In Your Stock Portfolio

A rise in interest rates can also wreak havoc on the stock market -- for two reasons.

First, higher rates can strain corporate finances: Some companies will have trouble borrowing to expand and increase profits, while others will struggle to meet their existing debt obligations.

There's also an investor angle: When bonds pay higher interest rates, or "yields," they look more attractive to investors, who could then yank money away from stocks to buy bonds instead. Some market pros even worry that if a widespread shift from stocks to bonds provokes heavy selling, it could trigger a long-awaited stock market correction.

One thing the Fed will certainly want to avoid is a repeat of 2013. At the time, then-Chair Ben Bernanke suggested the Fed might slow down, or "taper," the pace of its bond purchases, and bond yields spiked. Stocks grew volatile in response -- dropping 5% in June, gradually recovering, then plunging another 6% in August -- and the event later became known as the "taper tantrum."

In Your Home

Even if most of your wealth is in your home rather than a portfolio, there is a good chance that rising long-term interest rates could hit you.

Mortgage rates rise and fall with the bond market, with the 30-year rate typically pegged to the 10-year Treasury note. (That's because most homeowners typically keep loans for a decade, rather than the full term, before either refinancing or selling.) Indeed, market watchers are particularly worried about the mortgage prices because the Fed has been purchasing mortgage-backed securities along with Treasuries, and now owns roughly $1.75 trillion worth, more than a quarter of the market.

So far mortgage rates have actually fallen slightly this year, with the average rate 30-year loans at about 4.03%, down from 4.2% in January, according to Freddie Mac. Still, many forecasters still expect mortgage rates to ultimately rise in 2017.

What's more, any significant increase in mortgage rates would likely reverberate through the housing market, hurting home prices. Rising interest rates constrain the amount would-be home buyers can borrow, and by extension what they can offer to purchase homes. One recent Goldman Sachs research paper found that a 0.6-point increase in mortgage rates would knock about 2% to 3% off home values nationally.