Dangerous Investments Fueled by the Federal Reserve

Dangerous Investments Fueled by the Federal Reserve image 200313 IC cekerevacDangerous Investments Fueled by the Federal ReserveOne of the biggest concerns I have regarding the current monetary policy program implemented by the Federal Reserve is the cost that will need to be paid once the program ends.

While the Federal Reserve believes it can bring monetary policy back to normal levels without severe adjustments in the market, I don’t believe this to be the case.

Don’t forget that when interest rates rise, bond prices decline. Investors clamoring for any yield will suffer a massive decline in the price of the asset, all in the hunt for that small yield. As an example, in 1994, when the Federal Reserve increased interest rates, the price of the 30-year bond declined by 24% in one year.

The hunt for yield is so strong due to the aggressive monetary policy program by the Federal Reserve and investors are so worried about the possibilities of inflation that Treasury Inflation Protected Securities (TIPS), which adjust with the inflation rate, have been in such high demand that they now offer a negative yield.

According to the Lipper unit of Thomson Reuters Corporation (NYSE/TRI), for the last week of February, there was a record amount of cash moving into mutual funds that invest in floating-rate loans. (Source: Wirz, M., “Preparing for day when rates rise,” Wall Street Journal, March 10, 2013.)

The aggressive monetary policy program by the Federal Reserve is creating distortions in the market. The real worry is when the monetary policy program begins to tighten, shifting away from the current easy money policies.

With the Federal Reserve’s meeting scheduled this week, it’s interesting to note that a survey by the Wall Street Journal of 50 economists suggests that, by November 2013, the Federal Reserve will begin to slow down its bond-buying purchases, which will end by May 2014, and by July 2015, the unemployment rate is estimated to reach 6.5%. (Source: Hilsenrath, J., “Easy-Money Era a Long Game for the Fed,” Wall Street Journal, March 17, 2013.)

While those dates seem quite far away, investors in fixed-income securities will move much quicker than that. If there is any hint that the current monetary policy program will be adjusted, losses will be severe across the entire fixed-income spectrum, with the biggest losers being the longer-dated bonds.

One way to protect a portfolio is by shifting fixed-income assets from longer-dated to shorter-dated time periods. Once the Federal Reserve begins tightening its monetary policy, your portfolio should have a shorter duration, or time, until maturity, so that when the assets do mature, you can reinvest the funds at a higher level of interest rates and lower bond prices.

Because of the length of time that the Federal Reserve has been providing this current monetary policy program, complacency is a problem. Investors might fall into a false sense of security because there hasn’t been much volatility and little negative movement in the prices of fixed-income assets over the past couple of years.

However, it is extremely dangerous to believe that the bond market will continue to be quiet over the next few years. I believe there will be a large amount of volatility in the bond market, as the Federal Reserve adjusts its monetary policy and starts tightening it. If I owned extremely long-term-dated bonds, I would look to sell them and buy shorter-duration securities.

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