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One of the best known adages in the financial world is "don't fight the Fed." That however wasn't always so easy because of its policy of secrecy. Deciphering the Fed minutes was like the Oracle of Delphi priests trying to interpret the Pythia's vapor-induced messages from Apollo. The Fed's messages were so confusing they were given their own name, "Fedspeak," a word intentionally chosen because of its similarity with the "newspeak" of George Orwell's 1984. When I was a young student of economics over 25 years ago, I was taught this secrecy was necessary to prevent the markets from gaming the system and decreasing the efficacy of the Fed's monetary policy. Personally, I never understood why anyone would deliberately make an ambiguous statement, or how that would help do anything but create confusion in the financial markets, something I would think the Fed would want to avoid.

That was then:

Those days are over, however, and the Fed has embarked on a new era of openness and transparency. Headlines as unambiguous as "Fed Ties Rates to Joblessness, With Target of 6.5%," greet readers on the front page of the New York Times business section. More important than defining the targets, some Fed presidents are outlining the steps the Fed's monetary policy is likely to take in the future to reach its objectives. This is like Napoleon handing over the battle plan to Wellington before the battle of Waterloo. If the Fed is going to tell the financial markets its battle plan, investors would be wise to pay attention.

The Fed has essentially three tools in its toolbox to manage the monetary policy:

1) The rarely used reserve requirement.

2) The rarely used discount window and discount rate (read more).

3) Open market operations, and targeting the Fed Funds Rate.

For most of recent history, those tools proved adequate in managing monetary policy...and then came 2008. The Fed was faced with unprecedented challenges that forced them to "think outside the box" on an epic scale. Terms I had never even heard of, like "quantitative easing" and "operation twist," and tactics like paying interest on deposits at the Federal Reserve Banks as a way to unwind the current policy began to dominate the conversation. I became familiar with the Federal Reserve Balance Sheet like never before, and learned more about the actual implementation of monetary since 2008 than I had learned from studying it in the previous 25 years. The Fed had taken monetary policy into uncharted territory and was implementing policies never before tried in its history, influencing the markets like never before and setting in place a monetary foundation substantially larger than existed before 2008.

That was 2008, this in now. Talk is no longer about expanding QE or how many more there will be, talk is turning to "unwinding" what has been done. Prior to the 2008 crisis, the Fed's balance sheet was about $900 billion; today it is over $3.3 trillion, or over 3x what it was in 2008. Prior to the 2008 crisis, almost 100% of the Fed's balance sheet consisted of short-term treasuries, today it holds a portfolio which includes mortgages and longer-term treasuries. Sooner or later the Fed will have to "unwind" what has been done, and when it does, it is sure to move the markets. Fortunately for investors, the new Fed transparency, and simple common sense, make it easier to develop an investment strategy for the coming "unwind."

What do we know:

1) The Fed historically prefers controlling monetary policy by targeting the overnight Fed Funds Rate. I would imagine this is where the Fed is ultimately headed. A return to "normalcy."

2) The Fed has expanded its balance sheet by uncharacteristically buying longer-term financial assets. I view these as unwelcome but necessary house guests. By holding these longer-term assets, the Fed has exposed itself to interest rate risk, which I assume it prefers to avoid. The Fed, however, has to buy them if it wants to influence the longer end of the yield curve, and spur economic recovery.

3) When and if the economy begins to recover and unemployment heads down towards the target 6.5%, interest rates would be expected to increase to a level consistent with stable growth and 6.5% unemployment.

4) The Fed is unlikely to allow short-term rates to increase until unemployment gets to 6.5%. The Fed agreed to keep "short-term" rates low, not long-term rates.

The Federal Reserve on Wednesday agreed to keep a key short-term rate near zero until the 7.7% unemployment rate is 6.5% or lower.

Looking forward, a strategy to unwind:

Dallas Fed's President Richard Fischer is proposing a strategy of "tapering" that would represent the first shot fired in the battle to unwind. In my opinion, tapering would be the logical first step to unwinding. The rest of the unwinding should be just as logical, and I would imagine it would follow this strategy:

1) Taper buying bonds on the long end. This would slow the expansion of the balance sheet, and start to lift the pressure holding down the long end, allowing the long rates to slowly start gravitating towards their market equilibrium.

2) Stop buying bonds on the long end. This would remove the Fed induced market distortion, and allow the long end to fully reach their market equilibrium. This would signal the ending of expansionary monetary policy, and start off the neutral monetary policy.

3) Once the Fed stops interfering with the long end, the Fed will likely wait and see if the economy can sustain its growth with market rates on the long end.

4) Once the economy has proven its ability to sustain growth with market rates at the long end, the Fed is likely to pause until unemployment gets to 6.5%, or inflation develops.

5) Once economic growth reaches a level where the Fed decides to end the neutral strategy and implement a contractionary policy, the Fed will have three options:

A) sell long bonds and drive long rates higher

B) increase short term rates using the discount and fed funds rate

C) a combination of the two.

6) Complete the liquidation of all their long bond holdings and return to the traditional monetary policy using short-term instruments. This would represent a return to "normalcy."

Likely Impact of that strategy:

The above strategy should result in reasonably predictable results in the markets. Because the Fed has stated that it is going to keep the short end fixed at a low rate until unemployment reached 6.5%, it is effectively making a lever out of the yield curve with the short end being the fulcrum, and the long end being the lever. Think of a wheelbarrow, with the wheel axle being the short end and the long end being the handles. All the heavy lifting will occur at the long end. The handles can go up and down, and the axle will stay at the same level. Apply that principle to the yield curve and the result will be a "steepening" yield curve, where the long rates increase and the short rates remain fixed.

(click to enlarge)Yield Curve

Investment strategies for a steepening yield curve:

1) Reduce exposure to bonds at the long end. As interest rates increase at the long end, the value of those bonds will fall. More information on this topic can be found here.

2) Buy inverse bond funds targeting the long end of the yield curve. More information on this topic can be found here.

3) Buy a security that is specifically designed to perform well during a period of yield curve steepening. This topic needs further discussion.

iPath Steepener ETN (NYSEARCA:STPP):

STPP is an ETN that is specifically designed to capitalize on the steepening of the yield curve. It does this by buying long the 2-year treasury and shorting the 10-year treasury.

To accomplish this objective, the performance of the Index tracks the returns of a notional investment in a weighted "long" position in relation to 2-year Treasury futures contracts and a weighted "short" position in relation to 10-year Treasury futures contracts, as traded on the Chicago Board of Trade

STPP is based upon an index that has the objective of increasing 1 point for every 1 basis point (0.01) increase in spread/steepness between the yield on the 2-year treasury and 10-year treasury bonds.

Specifically, the Index seeks to achieve a 1 point increase in the Index level for each 1 basis point increase in the steepness of the yield curve and, conversely, to achieve a 1 point decrease in the Index level for each 1 basis point increase in the flatness of the yield curve, with minimal changes to the Index level in response to any parallel shifts in the yield curve

This chart highlights the historic relationship between the 2-year and 10-year treasury.

(click to enlarge)2 yr 10 year

The Current 10-year treasury rate is 1.92%, the current 2-year treasury rate is 0.25% and the current spread is 1.67%. The spread range has a maximum of 2.91%, minimum of -2.41, average of 0.90% and median of 0.85%.

(click to enlarge)2/10 spread

The index on which STPP is based tracks the 2/10 spread, but has shown some divergence since late in 2011. Most noteworthy is that the index did not steepen as much as the yield curve with the most recent steepening that began in late 2012.

(click to enlarge)Spread index

On 12/07/12, the 10-year spread was 1.34% and the index value was 71.25. Currently, the spread is 1.67%, and the index is 79.42. The spread increased by 33 basis points (1.67-1.34). This should have resulted in a change of 33 points in the index, but the index only changed by 8.17 points (79.42-71.25). Tracking error may be a problem with this ETN.

The ETN also has a "multiplier" of $0.10 that relates the index return to the ETN return. Every 1 point movement in the index should translate into a $0.10 change in the price of the ETN.

The effect of the Index Multiplier is to adjust the rate at which the value of the ETN changes in response to change in the underlying Index level. As a result of the Index Multiplier, the ETN will record a $0.10 gain or loss for every 1.00 point increase or decrease, respectively, in the level of the Index.

(click to enlarge)Price mvt

This chart demonstrates how well the ETN maintains the 10 multiplier.

(click to enlarge)Multiplier

This graphic highlights how the percent change in the index does not directly relate to the percent change in the ETN. The relationship is a linear relationship of $0.10 price change for each 1 point change in the index. The percent change of 1 point changes with the level of the index. A 1 point change on an index of 50 is a 2 percent change, a 1 point change on an index of 100 is a 1 percent change.

(click to enlarge)STTP perform

In conclusion, this new era of Fed transparency should provide opportunities for investors. The yield curve steepening strategy outlined above is a logical path for the Federal reserve to follow. If that is in fact the strategy the Fed employs, investors can benefit from properly structuring part of their portfolio as the implementation of the strategy unfolds. Strategies like 1) reducing exposure to the long end of the yield curve 2) investing in inverse bond funds targeting the long end and 3) investing in securities like STPP all are strategies worth considering. It is however important for investors to understand how these strategies will perform, and to set expectations accordingly. These are not buy-and-hold strategies. They are tactical portfolio adjustments to capitalize on the current Fed strategy. When that strategy changes, and the Fed starts lifting the short rates and begins to "flatten" the yield curve, these strategies will no longer be applicable, and the portfolios will need to be adjusted accordingly.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Source: Don't Fight The Fed: Investment Strategy For The Coming 'Unwind'