- To preserve wealth, consider 'Fading The Fed' (again).
- Investors should be wary of Fed optimism.
- Both conventional and unconventional monetary levers have been exhausted and are unlikely to work in the next pullback.
- It’s time to consider selling long duration bonds and raising liquidity for the likelihood of a coming period of rising interest rates and longer-term illiquidity.
If you were to have "Faded the Fed," in other words invested your portfolio contrary to what our central banking leaders were saying prior to both the Dotcom Bubble of 2000 and the Financial Crisis of 2008, you would have been smart. You might have been early, you might have seen some raised eyebrows, but you would not have regretted it.
On March 6, 2000, then Federal Reserve Chairman Alan Greenspan declared, "The fact that the capital spending boom is still going strong indicates that businesses continue to find a wide array of potential high-rate-of-return, productivity-enhancing investments. And I see nothing to suggest that these opportunities will peter out any time soon." Three days later, on March 10, 2000, the technology-heavy NASDAQ stock index would peak at its all-time high, 5048, and go on to fall over 72% the following 19 months to a low of 1423 in September of 2001.
In February of 2007, then Fed Chair Ben Bernanke spoke about the US housing sector: "There's not much indication at this point that subprime mortgage issues have spread into the broader mortgage market, which still seems to be healthy. And the lending side of that still seems to be healthy." These and other bullish comments were all made just months, and in some cases days, prior to the onset of the worst US financial crisis and housing market crash since the Great Depression.
Today, the US Federal Reserve and global central bankers are now confidently assuring investors that the economic recovery is progressing. Obviously, politics plays a part in that. The trouble is, they also are continuing to aggressively push their remaining monetary policy levers to the brink. After six years and zero interest rates and unprecedented asset purchasing programs, we now live in a surreal global financial environment with both global equity and fixed income markets at record highs, real estate, art and luxury markets booming. The Titanic band plays on, and investor complacency (fearlessness) is near an all-time high.
As David Stockman, former White House Budget Director under President Ronald Reagan, pointed out recently, however, "Zero-interest rate money for six years is inconceivable historically. It never happened before, even during the Great Depression." Why should we care? Because the upshot of zero interest-rate money is that it fuels bubbles. Investors are typically willing to take on more risk for less return when the "safe money" alternative is yielding nothing! And we should especially care because, as my headline warns, the expense and duration of the support central banks have devoted to trying to buy this recovery can't continue.
Today the greatest secular decline in both short and long-term interest rates and concurrent bull market in bond market history is now nearing its 35th year.
Monetarily, global central bank balance sheets have grown exponentially, adding over $10 trillion from a meager $1 trillion prior to the Great Crisis just six years ago. In the US alone, there are some that have argued that the Federal Reserve has already committed over $29 trillion in order to stabilize the world economy through the Crisis of 2008-9.
Here in the US, for nearly six years post the 2008 Financial Crisis of 2008-9, the Fed has pegged interest rates near zero percent. At the same time, they have implemented an unprecedented money printing scheme (quantitative easing) whereby enabling the Fed to essentially become the primary creditor to the US Treasury. No, it's not China or Japan but the US central bank itself. In fact, the Federal Reserve is the largest owner of US debt on the planet, owning more than both China and most of the Eurozone combined.
Senator Richard Shelby (R-AL) as a member of the Senate Banking Committee recently concluded that the Fed's massive purchase of US government bonds has been essentially a "backdoor stimulus program" that carries unpredictable consequences: "Make no mistake-the Fed's balance sheet will continue to expand rapidly. How long will this continue? We don't know. How large will the Fed's balance sheet ultimately grow? We don't know. Will the Fed be able to contain inflation if it does begin to rise? Again, we don't know. And when will the Federal Reserve actually begin to unwind the balance sheet-which will be tricky? Again, we don't know. How exactly does the Federal Reserve plan to unwind the balance sheet? Again, we don't know, and I don't believe they know."
Here's what we do know: Financial crises tend to occur about every seven years. Our last was 2007/2008. But this time, a fiscal policy remedy is nearly impossible with massive government debt already on the Federal balance sheet, unfunded liabilities skyrocketing into oblivion, and political will in Washington at a standstill. The prior decades' era of borrow and spend programs, stimulus packages, "cash for clunker"-like schemes and taxpayer bailouts have run their course. The fiscal credit card has been maxed out.
There are signs it may be time to fade the Fed. Current Fed Chairwoman Janet Yellen recently admitted that the Committee has been too optimistic about US economic growth prospects over the past few years and has now revised estimates downward for 2014. Not surprising to this author, however, is that at the same time the Fed is predicting a significant uptick in output starting next year with GDP estimates of 3% or above. Clearly a disconnect between the official statement and the hopeful forecasts.
There is a good chance the easy money days may soon disappear. The result could be relatively longer recessions, longer bear markets and most importantly, higher interest rates. Buy and Hold investors may find themselves holding underwater and/or illiquid financial assets much longer than ever before. For example, in the Great Depression, investors had to wait 25 years (November 1954) for the stock market to recover and break-even from the September 1929 low.
Prudent investors should consider selling any or all long duration bond portfolios. This would include long maturity fixed income mutual funds, ETFs, and managed fixed income portfolios. Neither government bonds, international bonds, mortgage backed bonds, corporate bonds, high yield bonds, or municipal bonds would be immune to a higher interest rate environment. In fact, if long-term interest rates were to return to their long-term mean yield of 6.50%, a 30-year US Treasury bond could lose up to 75% of its market value from today's low interest rates (high bond prices).
Now nearly six years past the 2008 Crisis, "Fading the Fed" and raising cash to preserve wealth may not be popular but may prove to be very smart once again.
Disclaimer: The views expressed are the views of Kirk Bostrom and are subject to change at any time based on market and other conditions. This material is for informational purposes only, and is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. The opinions expressed herein represent the current, good faith views of the author at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this article has been developed internally and/or obtained from sources believed to be reliable; however, the author does not guarantee the accuracy, adequacy or completeness of such information.