The Federal Reserve on Wednesday said it will slowly reduce the $4.5 trillion in U.S. securities that it bought up a few years back when it helped prop up a global financial system that was spiraling toward disaster.
With its hand firmly fixed on the interest rate lever, the all-powerful Fed has a big say in the price of everything from a loaf of bread to the homes we live in. Minus a long, boring dissertation that I don’t fully understand, the $4.5 trillion it gobbled up helped keep loans plentiful and cheap — providing the lubrication that kept businesses purring and, lately, roaring.
The days of so-called “easy money” will begin sliding away next month. The Fed announced Wednesday that it will begin selling its federal debt to the tune of $10 billion a month. At that rate, it will take 450 months to unwind — or 37 years.
At the same meeting, the Federal Reserve also hinted that it would gradually raise its federal funds rate. To keep this less complicated, let’s just talk about the implications of the “unwinding.”
So I called up some financial types to query them on what I should do. I am 62 and looking toward retirement in the not-too-distant future. I need my nest egg, most of which is in stocks and bonds.
The airwaves were full of chatter this week about how to defend oneself against the onslaught of higher interest rates. Some said buy gold. I heard one genius espouse emerging-market debt. (Me? I don’t understand it, but I once took some advice, dove in and lost thousands.)
So I asked: What do I do?
“Stay the course,” said Ivan Feinseth, chief investment officer at Tigress Financial Partners. “The stock market is going to go higher by the end of the year.” (Pssst. Feinseth is what we call a “bull.”)
“It’s not a strong move,” he said of the Fed’s unwind. Even I knew that. “Bond rates will go up very gradually.”
Bet on American businesses, he said, sounding like Warren Buffett.
“Corporate America is lean and mean,” Feinseth said. “Companies are earning record levels of return on capital. They are earning record levels of revenue. Look at Caterpillar and Boeing. Airlines are buying planes. Construction is booming. Infrastucture is about to boom. Just stay in stocks.”
Others were a bit more guarded in their outlook.
“The IV drip is off, and the economic patient is being weaned from the monetary narcotics,” said Michael Farr, president of the D.C. money management firm of Farr, Miller & Washington.
Though the Fed has been working very hard at saying the unwinding is not a big deal (as if $4.5 trillion of anything is not a big deal), Farr said people need to have clarity about what is happening.
“This is a concrete, albeit gradual, move to tighten monetary policy,” Farr said. “Rates are going higher, not lower. You never, ever ignore the Fed when the Fed changes direction.”
Hedge fund bigwig Ray Dalio of Bridgewater Associates said on CNBC last week that the current Fed situation was analagous to 1937, when the Fed tightened monetary supply as the U.S. economy was struggling to emerge from eight years of the Great Depression.
“Interest rates hit zero [back in 1929],” Dalio said. “And then the central banks buy a lot of assets, expand their balance sheets, print a lot of money to make up for credit. We have a rebound from ’32 to ’37. And the markets go to highs and everything is good.”
Then came the tightening in 1937, which threw the U.S. economy backward until World War II came along. Dalio said he was not predicting a similar outcome, but cautioned that we are in “a delicate period.”
Farr said investors need not charge toward the safe harbors of popular imagination such as gold, but people might want to be smart about how they navigate the next few years. You might think about parking some money in short-term bonds (two years or less) that can’t get buried by the rise in interest rates that are sure to follow the Great Unwinding.
“I have a client with $23 million, and he has half of that in short-term, two-year corporate and tax-free bonds,” Farr said. “He sleeps at night.”
The beauty of short-term bonds (I own a bunch through a Vanguard Short-Term Investment Grade Fund) in a rising interest rate environment is that they mature so frequently (every two years, duh!) that the fund is always buying new bonds that presumably pay higher interest.
But Farr said his client “has another $10 million in stocks. The stocks will go up, but they will correct. This stock market will go down. I don’t know if it goes down tomorrow or next year. But stocks will go down 30 percent.”
Which brings me to Jamie Cox, of Richmond, Va.-based Harris Financial Group. The Harris team manages $500 million in savings for around 800 middle-class families.
“For the first year or so, and maybe longer, investors will realize no real change,” he said. “They will see no net change in any of their investment as a result of the tapering. So at the front end of this, there is not much to be done.”
Cox recommends that if average investors are going to own short-term corporate bonds or Treasuries, they should buy them in a mutual fund or exchange-traded fund. He recommends Vanguard, Fidelity or Pimco.
If you are going to try to play the market and buy stocks you think will do well going forward, Cox recommends financial services like banks and insurance companies because they make bigger profits in rising interest rate environments. That’s because banks can charge more for loans like mortgages while not paying you more interest on your CD. He also favors technology stocks because they are unrelated to interest rates.
If interest rates rise over time, investors may seek alternatives to the rich dividends they had been collecting from sectors such as utilities, telecom and consumer staples.
“If I can get a certificate of deposit in a bank paying 5 percent with no risk,” he said, “then why would I own a big telecom or utility with the same yield but subject myself to the risks of the market?”
Right now, with interest rates between 1 and 1.25 percent, a 5 percent return looks a long way off. But on the way to that 5 percent, good things can happen, Cox said.
“If you do a historical analysis at what assets have done as interest rates have risen,” he said, “there is a sweet spot between 2 and 3 percent interest on short-term bonds where just about every asset class does great. There’s a long way to go before we get beyond three percent.”
Me? I’m not going to worry about it. I’m going to watch baseball.