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As the stock market continues to celebrate, the U.S. Federal Reserve finds itself in an increasingly tightening box.

The Fed emerged from their latest policy meeting on Tuesday with a notably more optimistic tone about the U.S. economy. They also paid greater attention to inflation, although they suggested that any such pricing pressures would be temporary. The key takeaway from the latest Fed announcement was that it seemed to be trying to lower market expectations for any new Fed stimulus programs once Operation Twist draws to a close at the end of June.

Perhaps the most surprising development coming out of the Fed meeting was the reaction by the stock market (NYSEARCA:SPY), which gained over +1% following the Fed's announcement. And the momentum kept going for the remainder of the week, as stocks tacked on another +0.6% by Friday's close to break out to new post crisis highs. Given that stocks have been so heavily influenced by monetary policy over the last three years - soaring when stimulus is applied and collapsing once it is withdrawn - this week's reaction was curious to say the least.

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While I heard some proclaim that the stock enthusiasm was driven by the idea that economy is now ready to take the lead in driving stocks higher once stimulus is removed, this is conclusion that is subject to serious debate. Sure, the U.S. economy has shown some signs of improvement, but the pace of the recovery remains fairly sluggish. And the growth outlook outside of the U.S. is far from encouraging with Europe already in recession and still teetering on the brink of crisis and Asia also slowing. Lastly, the idea that the economy was sufficiently strong to support stock prices was the same story being told back in April 2010 and July 2011 after QE1 and QE2 concluded, respectively. And in both cases the Fed was scrambling back in within weeks with promises of more stimulus as the stock market quickly collapsed without the Fed's support.

The Fed's decision to apply additional stimulus becomes increasingly more complex with each successive round. QE1 was launched in March 2009 to rescue the financial system with few questions asked. QE2 was preemptively rolled out in August 2010 by a Fed that had the swagger of having pulled the economy back from the brink with QE1. But by the summer of 2011 with the economy still sluggish and asset bubbles clearly forming in markets such as stocks and commodities as a result of these stimulus programs, the political scrutiny was building on the Fed. As a result, the Fed went the backdoor stimulus route with Operation Twist in October 2011. Although it is effectively QE3 - if banks are receiving what are essentially cash equivalents from the Fed in exchange for assets, it has the same effect as the banks receiving cash - it is still not being interpreted this way by a good portion of market participants. And while Operation Twist has succeeded where QE1 and QE2 had failed in keeping bond yields low, it is still creating the same spillover effect that may ultimately bind the hands of the Fed in the end.

Here is the box in which the Fed is now trapped. Operation Twist ends in June. This program just like QE1 and QE2 before it have succeeded in two respects. First, it has caused the stock market to consistently rise. Second, it has provided support to the idea of an improving economy. But it is also failing in certain respects. Perhaps most significantly, monetary stimulus has also caused inflationary pressures such as oil and gasoline prices to rise just as much if not more so than stocks.

So if the Fed decides to stand down from further stimulus, oil and gasoline prices are likely to ease, but the stock market is also likely to fall sharply and worries about the economic outlook are likely to resurface. Conversely, if the Fed opts to launch another stimulus program, stocks will potentially continue to melt higher and the economic outlook would presumably remain bolstered, but inflationary pressures including oil and gasoline prices are likely to continue to rise to potentially unpalatable levels for most Americans. Public agitation about spiraling inflation and the Fed's role in fostering it would also likely be fully unleashed.

The timing this time around makes the Fed's spot particularly tricky. As we all know, 2012 is a presidential election year. And given that it is already under a political microscope, the last thing the Fed wants to do is to be perceived as acting for or against any political party leading up to the November election. Thus, it will need to tread very carefully with the timing of whatever policy prescription it chooses in the end. For example, the Fed will have far less flexibility from a political perspective this summer to wait after the end of Operation Twist in June in deciding whether to apply more stimulii. The longer it waits, the more it backs up on the peak of the election season.

For these political reasons, the Fed most likely would like to launch a "sterilized QE" (Operation Twist 2 (stealth QE4)) starting in July that would link up with the end of Operation Twist (stealth QE3) that ends in June. But here's the added dilemma for the Fed. As long as the economic data continues to come in "better than expected" and optimism builds about the prospect for an economic recovery, the more difficult it will be for the Fed to justify launching any new stimulus program. Instead, they may be forced to wait for renewed signs of economic and stock market weakness before being able to justify rolling out an Operation Twist 2. But by then, it may be too late from a timing standpoint in the heart of the election season.

So while the stock market continues to celebrate in a stimulus induced high, a great deal of uncertainty lies ahead about whether this monetary support will still be there in a few months. Certainly, the fiscal policy support is increasingly rolling off as we move toward 2013, which is an added challenge for the economy and markets in its own right.

Given these uncertainties, the best investment strategy is to position against the various outcomes. More stimulus likely means more inflation. Thus, allocating to those asset classes that are likely to benefit most from rising pricing pressures. These include U.S. Treasury Inflation Protected Securities (NYSEARCA:TIP), gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV). Stocks would also likely continue to benefit under this scenario, although gains are likely to become increasingly concentrated going forward. Areas of interest under this inflation scenario would be direct oil plays as well as those focused on oil substitutes such as Murphy Oil (NYSE:MUR) and Ultra Petroleum (NYSE:UPL).

On the flip side, no more stimulus likely means a sharp stock market correction and renewed recession and crisis fears. Thus, allocating to those asset classes that are likely to hold up best in such a scenario is also warranted. These include stable and defensive segments such as Agency MBS (NYSEARCA:MBB) and Utilities stocks such as WGL Holdings (NYSE:WGL). Gold would also likely perform well under such a scenario. And nominal Long-Term Treasuries have proven a consistent way to protect against a decline in the stock market, as securities such as the iShares +20 Year U.S. Treasury Bond ETF (NYSEARCA:TLT) have soared during phases when the stock market is cascading lower.

It will be interesting to see how the Fed decides to play it in the coming months. But the one thing that is certain is that their choice will not be an easy one at the end of the day.

Disclosure: I am long GLD, SLV, TIP, TLT, MUR, UPL, WGL, MBB.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Source: The Fed In A Tightening Box