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Summary

  • Fed reinforces view that social policy (employment) outweighs financial stability (markets).
  • Financial market makers beware! New limits and risk policies are on the horizon.
  • The "put option" is still in play.

Yesterday afternoon our Federal Reserve chairperson presented to the International Monetary Fund in Washington, DC. The speech did not break any new policy barriers, but there are several points that Ms. Yellen emphasized which should cause investors to take pause and to re-evaluate certain assumptions that seem to be widely held in our current financial environment. The first assumption which has been cast into doubt is that the Federal Reserve stands ready to use monetary policy to help alleviate periods of financial instability. Although it was not expressly stated, the chairperson was pretty clear in her assumption that monetary policy is a crude and potentially ineffective tool for promoting stability.

"I will argue that monetary policy faces significant limitations as a tool to promote financial stability: Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment."

Chairperson Yellen - 2-July 2014

In my opinion, there are two things to take from this statement:

  • Monetary policy is not the preferred tool for the current Fed to address stability
  • Volatility of employment trumps volatility in markets in the Fed's hierarchy

So what does that mean?

First, I believe that the Federal Reserve is laying the foundation for increased regulatory controls and oversight on the horizon. It seems to this analyst that the remarks of the Fed Chairperson are intended to signal that the preferred approach for addressing matters of stability will be regulatory control in nature. As an example, the Chairperson highlighted the effectiveness of several international jurisdictions that opted to lower interest rates towards zero, but simultaneously increased lending standards. The message is clear - the Fed prefers regulation to 'printing money,' and our markets will feel this impact in the coming quarters. The potential roadmap of regulations is as follows:

"…I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach"

"…Some of these measures--such as requiring firms to hold larger amounts of capital, stable funding, or highly liquid assets based on use of short-term wholesale funding--would likely apply only to the largest, most complex organizations. Other measures--such as minimum margin requirements for repurchase agreements and other securities financing transactions--could, at least in principle, apply on a marketwide basis."

Chairperson Yellen - 2-July 2014

Second, the Fed did leave open the door for the continuing put option to rescue reckless investors. The chairperson relegated monetary policy changes to the back burner, but did not shut the door on the Fed's current policies of pumping up asset prices.

"…It is therefore important that we monitor the degree to which the macroprudential steps we have taken have built sufficient resilience, and that we consider the deployment of other tools, including adjustments to the stance of monetary policy, as conditions change in potentially unexpected ways."

Chairperson Yellen - 2-July 2014

So, the good news is that the "put option" on the SPY and other risk assets is still in place. However, it seems that Ms. Yellen has moved the strike price out a bit, and hopes that regulatory measures will take precedence in reducing reckless risk-taking.

Investment Implications

There is no shortage of opinions about the potential direction of financial markets, and the prognosticators of gloom and doom (as I have been called) are consistently underperforming the optimists in this current market. Nonetheless, investors should not overlook the desire of the Fed to rein in risk taking with rules and controls - and we have seen in the past that these types of policies are harder to change once they're put in place. It should be noted that regulatory controls are also, oftentimes, catalysts for unintended consequences.

In my March 31 article, I proposed selling December 187 call options on SPY and purchasing June 179 puts on the SPY. I also modified my preferred asset allocation to reduce holdings in PFF and move into shorter tenors on the yield curve (MUTF:FSTIX). With 90 days of market movements, I'm underperforming, as the SPY equity index has risen from 187 to 197, and the preferred stock ETF has rallied another 3%. Forecasting markets risky business - you don't always win! Nonetheless, as I look into the next quarter, I haven't seen any indications that my current allocation requires changes. I will suggest that the residual option premium from selling calls can now be used to purchase Sept 30 puts on the SPY. At the time of writing, the Sept 30 SPY 187 puts can be bought for about $1.70. Without the option overlay, the recommended asset allocation remains as:

Asset

Conservative

Aggressive

Income

Cash

15%

0%

5%

Fixed Income

60%

20%

55%

Equity

25%

70%

35%

Commodity

0%

10%

5%

  • Within the fixed income category, stay on the short end, using FSTIX.
  • Within Commodities, the portfolio is long GLD
  • Within Equities, the mix is as follows:

Asset

Allocation

SPY

80%

IWM / SCHA

5%

EEM / SCHE

5%

EFA / EFV

10%

Disclosure: The author is short SPY, long GLD, long SCHE, long VZ, long FSTIX. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: The Fed Sounds The Regulatory Bell