Investment Contrarians

What the New Federal Reserve Monetary Policy Plan Means for Your Investments in 2013

By for Investment Contrarians |

New Federal Reserve Monetary PolicyThe Federal Reserve concluded its latest meeting on Wednesday by enacting additional monetary policy measures and a historic change in the way the central bank communicates its intentions.

With “Operation Twist” ending this December, the Federal Reserve decided to continue its monetary policy program of purchasing $45.0 billion of long-term treasuries each month. This is in addition to the ongoing monetary policy program of purchasing $40.0 billion of mortgage-backed bonds per month. (Source: Press release, Federal Reserve web site, last accessed December 12, 2012.)

This action by the Federal Reserve is not really a new monetary policy initiative, but a continuation of the existing plan, Operation Twist. The Federal Reserve still sees a weak American economy that it believes needs additional stimulus.

What is new for the Federal Reserve is that this $45.0 billion per month will not be financed by selling short-term debt, but will be outright purchases of long-term treasuries. Instead of sterilizing the bond purchases, this will now be outright money printing.

Another change for the Federal Reserve is that it no longer uses a calendar for an end date; it now looks for quantitative metrics based on which it will look to end its monetary policy programs. The guidelines they set out are for easy monetary policy “…at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s two percent longer-run goal, and longer-term inflation expectations continue to be well anchored.” (Source: Press release, Federal Reserve web site, last accessed December 12, 2012.)

Since the financial crisis, the Federal Reserve has purchased approximately $2.4 trillion in treasury and mortgage securities. This has certainly helped the economy in certain areas, especially housing. The problem, as I see it, is that the Federal Reserve initially had the right idea with monetary policy, using it during periods of crisis. However, I believe that the current monetary policy plan is trying to do too much and will have serious unintended consequences down the road.

The other danger that many people don’t realize is that, at the current trajectory in the decline of the unemployment rate, many market participants will start worrying about the tightening of monetary policy by the Federal Reserve this time next year. Investors have been pouring into bonds, which is a dangerous mistake in an environment of rising interest rates.

Since the beginning of 2008, bond funds have had almost $1.1 trillion of inflows, and equity and money market funds have had outflows of $793 billion, according to data provider EPFR Global. (Source: “Desperately Seeking Yield,” The Economist, November 10, 2012.) One does not want to be heavily weighted in long-duration bonds while monetary policy starts to tighten over the next several years.

Don’t forget, the market always looks eight to 12 months ahead of time. Next year, when the unemployment rate declines below seven percent, market participants will begin discussing when and how fast the Federal Reserve will start raising interest rates and reducing liquidity. With the federal funds rate at approximately zero percent, and a normalized rate of three to four percent, this will be a substantial increase in interest rates.

Many of the investments that have gone up since the easy monetary policy action started in 2008 will begin to reverse, causing a lot of volatility. While we may continue the bullish ride in many asset classes for the next few months, I think investors should start taking profits in those investments that have gone up tremendously over the past few years.

While the Federal Reserve estimates that unemployment will decline to below 6.5% by 2015, the market will react far sooner than that. I would suggest that investors start incorporating a tightening of monetary policy some time next summer or fall.

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