Forget 'Don't Fight The Fed' - It's Time To Fed-Proof Your Portfolio

by: John Tobey, CFA

Hard hat signIn obedience to the mantra, "Don't fight the Fed," investors have remained committed to the process of Fed meets, Fed announces, markets react accordingly. Strongly supporting that belief today is the past four years' results. Longevity and repetition have convinced investors and even most of the Fed's committee members that this wonderful situation is a basic truth. Moreover, most also believe that the Fed's easy money policy produces a win-win situation for everyone.

However, current conditions and a deeper analysis show both the fallacy and danger of acting on this mantra. The Fed's easy money policy now is looking more and more like an unwise investment foundation. Also, there is growing commentary that questions the "omni-beneficial" label.

Even Wall Street is shifting from being mostly supportive of the Fed's easy money policies to being less enthusiastic, even a bit contrarian. These reasoned views (not anti-Fed rhetoric) are warning signs that the Fed's policies could be in for more questions, skepticism, even criticism. Therefore, we should drop the "Don't fight the Fed" investment strategy and begin to think about ways to Fed-proof our portfolios.

The Fed's two-part, easy money programs

Forget about program particulars. Instead, focus on the two basic policies: A 0% money-market rate policy and a bond-buying, money-creation policy. The Fed has used these approaches to make money easy - historically, VERY easy - for an unprecedented four years. Not so consistent is the professed rationale for these policies, which has morphed as the financial crisis passed, the economy recovered, housing improved and unemployment fell by 25%. (In typical fashion, the Fed just used the recent Cyprus headlines to highlight "international risks" as an excuse for keeping money easy in the U.S.)

Judging by the majority of comments, the positive returns in the bond and stock markets along with the improving economy "prove" the Fed's policies are appropriate and correct. Ignored (until recently) are the significant and serious dislocations in the economy and financial system caused by these policies. Those effects continue apace, building in size and producing abnormal expectations and actions. Here's the damage being done by the two policies:

First policy: 0% interest rates = massive harm to all savers

Wednesday, 3/20, on CNBC: Low Fed Rates 'Akin to Price-Fixing': JPMorgan Strategist

The Federal Reserve's near-zero percent interest rate policy is hurting savers and keeping a lid on consumer spending, David Kelly, chief global strategist at JPMorgan Funds, told CNBC on Wednesday.

The central bank's bond-buying has not helped the economy any more than it would have without the quantitative easing program….

"Hurting savers" is the key. The Fed has turned that argument around, saying it has successfully encouraged people to help the economy by not keeping money squirreled away, but putting it to work in riskier investments. That logic is grossly flawed.

First, money flowing into savings deposits efficiently moves into the financial system to be used by banks and others for "riskier" investment activities. Conversely, individuals buying bonds and stocks in the secondary markets don't have that same, direct effect.

Second is a basic fact about savers vs. investors: Savings deposits are held mainly by savers, not investors. These are the millions of people who don't have the assets, knowledge or desire to put the money they've set aside into investments. Now, let's measure the effect of 0% on these savers.

Note: I learned the lesson of savers vs. investors while I supervised the investment management of Bank of America's pension and savings plans (1982-1986). I had believed most savers would, with education, "graduate" to being investors. However, in helping redesign both plans, I had a survey conducted that completely altered my thinking: Most employees are savers, not investors. This meant that "educating" and "weaning" people out of their savings and into risky investments was a disservice. That led me to getting the bank to change the savings match from Bank of America stock only. From that experience, I adopted a successful, long-held belief: The average employee is not an average investor.

How bad is the "hurt" from the 0% yield? Lost interest = $1/2 trillion

In spite of earning close to nothing, savers continued to hold trillions in savings accounts. What would the interest rate have been without the Fed policy? Probably about 2%, in line with historical lows and the inflation rate. So, we can now measure the hurt: 2% for 4 years, compounded = 8.24%. (Compare that to Cypress' proposed 6.75% and 9.9% deposit tax, averaging 8.33%. The difference? Cypress is trying to raise less than $8 billion; the Fed garnered about $450 billion.) For perhaps better perspective, that Fed-caused loss of interest is almost ½ trillion, and counting.

So, where did that largess go? To the banks that didn't have to pay a market rate of interest for the deposits. Why didn't the depositors leave? Because of that underlying characteristic known by all bankers and the Fed: Most savers are not investors. Bankers know that savers will leave their funds on deposit even when the bank pays them next to nothing. In fact, during the four years, savings accounts grew over 60%, from $4.1 trillion to $6.7 trillion. (Recently, one writer improperly used this savings growth as proof that "investors" remained overly risk averse, so the Fed is correct in keeping interest rates at 0% until that unhealthy condition is rectified.)

Savings and small time depositsClick to enlarge

Now, think about the Fed and the banks and how they must view those savings deposits - as a "cash cow" that can be milked. Certainly, by keeping the 0% interest rate in place, they have rationalized that it is somehow proper (morally and ethically) to pay nothing to the millions of savers who, by personality or circumstance (think retirees and "widows and orphans"), are unwilling to buy riskier investments. (Another view: The 0% policy is equivalent to a 100% tax of the interest savers would have earned if the Fed had allowed rates to be determined naturally.)

Note: This critical analysis is not a Fed-roast. Rather, it's the "other side of the coin" that has been little discussed, showing that the Fed's policy is not a simplistic win-win. Importantly, based on recent comments and articles (like the one above), that fact is starting to be revealed. The fallout from this exposure means there is a real risk that there could be a campaign against the Fed's 0% policies on behalf of savers (think AARP, investigative reporting, congressional write-ins, internet-based activities). Such a campaign could embolden the as-yet naysayers on the Fed committee, tarnish the Fed's image and, more to the point, derail its ability to continue its 0% policy. This risk is what we need to be aware of and be prepared for.

Second part: The monster in the closet that won't go away - Inflation

All who lived, worked and invested during the late 1960s through the early 1980s know firsthand inflation's destructive and demoralizing attributes. They also know that analysis of current price trends provides no insight whatsoever into future price trends. That italicized basic truth periodically needs to re-learned by new generations of leaders, economists, academics and investors - and here we are again. (Said another way, when the Fed's survey of people's future inflation expectations finally ramp up, it will be because inflation has ramped up -- not because the average person has suddenly become prescient.)

The 1960s - 1980s inflationary period was built upon two primary notions: First, that war debt (starting with World War II) shouldn't be paid off quickly because that policy produced serious economic reversals in previous post-war periods. Second, Keynesian economic theory was accepted, in which government spending was viewed as a catalyst for growth (the belief was that $1 of government spending begat a much larger amount of GDP growth).

Note: OPEC is often mentioned as the cause of double-digit inflation, but that was only one of many influences. The key problem was too much money - through government borrowing, bank lending and rapid money "velocity." Investor and consumer attitudes were adversely affected by attempted price controls, the final removal of gold convertibility, rationing (not just of oil), the ballooning debt from the Vietnam War and economic malaise with large corporations stumbling.

But that couldn't happen again, right? Well, history never repeats in exactly the same way. However, there is one constant that does repeat: Human folly - particularly when it comes to grand economic and financial schemes. This Fed has given us a new, risky position through the building of gigantic excess bank reserves. Equivalent to an unlit bonfire pile, these reserves are capable of producing intense inflationary heat if (when) ignited. Yes, there is a small, 2% inflation flame today, but that doesn't make the risk of a larger conflagration small.

Excess and required bank reservesClick to enlarge

Important: Even though the reserves arose from laudable motives (improving the economy, financial system, housing and employment), we are, nevertheless, exposed to the risk of undesirable consequences harming us. Financial laws do not distinguish between good and evil intent - they are based solely on the action.

The Fed, using a responsible and reasoned demeanor, will attempt to assure us that if the reserve pile is ignited, it (the Fed) will take quick, remedial action. This is false comfort for two reasons. First, it will not see it coming (that basic truth again). Second, the magnitude of the reversal is too great to be either financially or politically acceptable. Rather, the Fed likely will devise other, tepid responses similar to what its predecessors did.

There were only two successful inflation fights waged in the last 100+ years. The first was at the end of World War I, when the traditional pay-off-the-war-debt policy killed the then-high inflation while also throwing the economy into a "depression" (what we now call a deep "recession"). The second was the years-long battle waged in the early 1980s by Fed Chair Paul Volker. With President Reagan providing the hope and optimism, Volker was free to deal with the reality of double-digit inflation (and interest rates) amid a poorly functioning economy. His approach was classic (and painful): Crimp money supply growth in order to squeeze out the excesses.

Note: I am not forecasting a jump back to anything like double-digit inflation rates. Reaching those levels takes not only the right conditions, but also the right mindset, and that takes years. Rather, the risk is the Fed's 2% upper limit becomes 2.5%, then 3%, etc. This ratcheting up is what happened before and would most likely happen again, particularly as the economy and employment rise. Then, the focus will be on capacity limits, resource scarcity, etc. - seemingly, all happy characteristics of a healthy economy, thereby making higher inflation rates palatable.

The bottom line

It's time to drop "Don't fight the Fed" as a reason for investing. First off, that rationale is too widespread to produce superior returns. Second, the possibility of a shift of the investor viewpoint away from its strong-positive level could produce good returns from contrarian investments (because the shift would be unexpected).

Aided by the increasing number of negative articles about the Fed's policies' distorting effects, we could see that strong-positive viewpoint shift in the near future. Add in any sort of widespread recognition of the plight of savers and the mood could turn decidedly anti-Fed.

So, forget the "relax and invest because the Fed's at the controls" attitude. Like the emperor with no clothes, people are beginning to notice the Fed's lack of all positives.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Positions held: 100% cash reserves