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It has been a little over a month since Chairman Bernanke spoke and the market responded. The Fed Chairman said vaguely something to the effect that he was fixin' to get ready to begin thinking about tapering the size of bond purchases - if the economy continued to improve. That was not news. The Fed board has been saying for a long time that it will slow bond purchases when the economy healed.

Since the beginning of quantitative easing, the Fed detractors have been saying the opposite, warning investors that the Fed wouldn't stop the QE program, and this out of control money printing will create high inflation. If this charge were true, it seems the Fed statement would be welcome news. As shown in the chart below, the news was not welcomed. After the statement, almost every asset class was down 3 to 7 percent over the next month.

click to enlarge images

With almost all markets down the money must have stayed mostly in cash, with no clear indication yet where it will go from there. One anomaly is mortgage bonds, which represent about half of the Fed's bond buying, were down 2 percent while Treasuries, the other half, were down about 7 percent in the following month.

The reaction to the Fed comments have caught most by surprise. A threat of rising interest rates is not new and the mention of them shouldn't be a surprise, but it was. The detrimental effects of rising interest rates for are well known. Among other problems increasing rates cause bond values to decline and raise capital cost for companies. On the positive side, increasing rates raise the yields for fixed income investors.

Taking The Carry Away From The Carry Trade

Low interest rates lower the cost of capital and this allows investors to borrow money at low rates and invest it at higher rates. This is called a carry trade. For instance, if an investor can borrow at one percent and buy a bond that yields three percent then they can keep the difference or the carry. This strategy is mostly accomplished by sophisticated investors, but ordinary investors participate in a version of this when they buy bonds on margin, leveraged closed-end funds and mortgage REITs .

As long as the interest rates don't change, carry trades are easy money. The current Fed talk of lower bond purchases and the possibility of higher short-term interest rates threatens to derail this gravy train. That is a major part of the scare in the market.

If The Fed Isn't Printing Money, You Can't Stop Them

Before discussing what the Fed actions will do, a quick review of what they are not doing will be helpful. There is a steady drown in the media from pundits that the Fed is printing money, but they really aren't, or at the very least, they are not printing much. What they are doing is buying bonds with bank reserves.

Most measures of the money supply don't count bank reserves as money. Under the broadest monetary measures, QE has doubled government base money or publicly-produced money, increasing it from about 7% of the broad money supply to about 15 percent. The Fed has doubled a very small part of the money supply. The remaining 85 percent of the money in the economy is privately-produced from bank credit which has been shrinking. When banks make loans they create money. The additional seven-percent created by the Fed has not been enough to overcome the reduction of privately produced money created by shrinking credit.

This is why, in spite of the money printing claims, nobody seems to have more money. Corporate revenues are flat, wages are flat, state and federal budgets are decreasing, cites are short cash. So if the Fed is printing money - where is it? If the Fed were really printing money you would notice. Much of our economic problems are because the broad money supply is growing too slowly, as shown in the below chart.

To prevent the bank reserves from turning into bank credit, the Fed changed its policy after the financial crisis and is paying interest on the reserves. These interest payments discourage banks from lending out the reserves. If it was the Fed's intention to increase the money supply, they would not be paying this interest. Paying interest on reserves allows the Fed to buy bonds and lower interest rates without increasing the broad money supply. With QE the Fed is basically exchanging an interest paying federal bond for interest paying bank reserves without the expected increase in bank credit.

An Artificial Bond Shortage

What the Fed is doing is driving down interest by creating a shortage of government bonds. They are buying almost all of the newly issued bonds, leaving few left for the rest of us. This shortage of bonds lowers interest rates and causes the 85 billion per month that would have been spent by the private economy on government bonds to be reallocated to other investments, like the stock market, raising the price of those assets.

What this means for investors is: first, there is no significant increase in the money supply and for that and other reasons inflation is not a problem in the near term and second, if the Fed does taper there will be 85 billion fewer dollars in the economy to invest in other assets, like the stock market. This potential increase in available bonds is also behind the sell off.

There will however be more interest coming into the economy. When the Fed buys bonds the interest on those bonds is not circulated into the economy, but is returned to the federal government uncirculated. If the bonds are instead sold into the broad economy, the interest payments will go into the economy and not back to the government.. This will be good for savers and bad for borrowers.

Investment Strategy

As Yogi Berra said, "predictions are very hard, especially about the future", but there are a few future scenarios that investors can plan for or against.

1) The economy continues to struggle and the Fed continues to buy bonds. In spite of the jawboning in this scenario the Fed does nothing and continues to buy 85 billion a month in bonds into the future. There is a hypothesis in the press that the Fed can't buy bonds forever and it seems to make sense. But, it's not true. The Fed in fact can keep buying bonds for the next hundred years if it feels like it. The bonds all mature so the money comes back. There is plenty of evidence that the economy is not in good shape and the Fed can't risk raising rates anytime in the near future.

If the Fed does nothing, there will be a continuing shortage of government bonds and interest rates will stay low and potentially go lower. There will be 85 billion per month that can't be used to buy government bonds and must go into other investments like the stock market.

This scenario will be favorable to the stock market (NYSEARCA:SPY), possibly gold (NYSEARCA:GLD), and any non-bond investments. This scenario also means the economy will still be struggling. The recent sell-off will be seen as an overreaction and money will flow back from where it came, back to Treasuries (NYSEARCA:TLT) and mortgage bonds (NYSEARCA:MBB). Carry-trade investments like Mortgage REITs (like NLY, AGNC and REM) and closed-end funds (like PCEF and FOF) will continue to perform well.

2) The economy improves and the Fed tapers its buying slowly. This is what Dr. Bernanke is saying he will do if the economy improves. An improving economy will be a boost for the currently flat corporate revenues.

A slow tapering is unlikely to raise rates rapidly or to raise rates above where they were before the QE programs commenced. The ten-year rate was around 3.2 before QE started and is currently about 1.75 percent. This scenario will be neutral for the stock market as corporate revenue rises but is offset by the availability of more federal bonds in the market.. A good place in this case would be high-coupon premium bonds that are less reactive to interest rate increases.. Also, mortgage-backed bonds (like MBG and VMBS) were less reactive to the recent disruption and may perform better than Treasuries.

3) The economy improves and the Fed rapidly stops buying. This is the least likely scenario. It will cause interest rates to spike and corporate funding cost to rise rapidly. Money will quickly flow into the bond market away from other investments. This will cause havoc in the system and cause trouble throughout the economy. If this happens the best place to be will be cash..

4) The economy worsens and the Fed increases its buying. This is the wild card nobody seems to be planning for. But, the economy is not all that great, what if it takes turn for the worse? What if the problems in Europe and China spill over into the US and the effects of the Sequester put downward pressure on the economy.

In this case, we can be certain there will be no action to stimulate the economy from the Congress. Fed monetary action will be the only viable option. In this case, the the Fed could flip-flop and decide to increase it's buying of Treasuries. This will be favorable to Treasuries and other fixed income investments.

Investment Strategy

Given these four possible scenarios what the best strategy? I believe that as long as the economy has an output gap of 5 percent, like it does currently, the Fed will keep buying bonds. The below graph shows the yet to be closed output gap between the economy's potential GDP at full employment, full capacity and the current GDP. There is clearly no improvement showing in this data.

Compare that chart to the money supply graph below and there is a correlation. We need to see actual growth in the money supply before we will see significant growth in the economy.

Investors should design their portfolios to match what they believe is the most likely scenario. The best strategy is to barbell your portfolio with a portion that will perform if interest rates stay low, as they are now, and a portion that will gain if they rise you will also gain or at least not get hurt too badly.

Now that the Fed has seen what a mention of tapering does to the markets they will be even more cautious about it's execution when and if the time comes. In this case, there is opportunity still available for knowledgeable investors to use cushion bonds and preferreds as a barbell. If rates stay low there is a decent yield, if they rise the effects will be less severe. Also, if rates stay low there are also short-term opportunities in carry-trade investments, like closed-end funds and mortgage REITS, that may have over corrected in the recent sell-off.

Disclaimer: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.

Source: Navigating Your Portfolio Through Fed Speak