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Navigating the shift to a stingier Fed

What investors need to know as the Fed ponders trimming its stimulus plan

July 05, 2013|By Tom Petruno
  • The market volatility seen since the Fed hinted it was prepared to trim its stimulus program points to investors' need for a new road map to guide the way in what may continue to be rough market terrain.
The market volatility seen since the Fed hinted it was prepared to trim its… (Joel Kimmel, For The Times )

After four years of providing trillions of dollars in cheap money to prop up the U.S. financial system and economy, the Federal Reserve has signaled that its generosity won't last forever.

On the face of it, that ought to be good news: It means the economy, and particularly the labor market, are getting healthier.

But as the last two months have shown, the transition to a stingier Fed isn't likely to be easy for global markets.

Stocks, bonds, commodities and currencies have experienced wild swings since mid-May, when the Fed began to hint that it was preparing to pull back on "quantitative easing," or QE — its program of pushing cash into the financial system via $85 billion a month in Treasury and mortgage-bond purchases.

Markets had another volatile day Friday, after the government said the U.S. economy created a net 195,000 new jobs in June, well above expectations. The report was further evidence that the Fed could look toward dismantling the economy's training wheels.

Stocks surged Friday, bond yields jumped and gold plummeted.

For investors, all of this points to the need for a new road map to guide the way in what may continue to be rough market terrain.

Here's a look at some of the most important issues investors need to understand as they think about their portfolios in the next chapter of the economy's recovery:

First, realize that it's early in the game — and a lot could change. The Fed hasn't committed to cutting back on its stimulus program; it has merely said it is "prepared" to reduce its bond purchases if the economy continues to look better.

Likewise, if the backdrop were to worsen in July and August, Fed Chairman Ben S. Bernanke could quickly signal that the central bank still isn't ready to take its foot off the gas.

But for now, many Wall Street pros are leaning toward the idea that the Fed this fall will begin "tapering" its bond purchases. Instead of buying $85 billion a month, it may buy, say, $60 billion.

"The Fed will indeed test the taper waters, perhaps as soon as September, and the financial markets will need to continue to adjust to a post-QE3 environment," said Scott Anderson, chief economist at Bank of the West in San Francisco.

Note that the Fed isn't yet talking about shutting off stimulus completely. But after becoming heavily dependent on the Fed's largesse since the 2008 economic crash, markets already are reacting even to the thought of less Fed money flowing into the financial system.

Cash still won't pay, perhaps for years. Investors hoping to earn more in cash accounts, such as bank savings certificates, will face more disappointment. Even if the Fed allows longer-term interest rates to rise by slowing its bond purchases, policymakers aren't planning to raise short-term rates soon from their near-zero levels.

In its post-meeting statement in June, the Fed said its rock-bottom benchmark short-term rate "will be appropriate at least as long as the unemployment rate remains above 6.5%." The June rate was unchanged at 7.6%.

Until the Fed raises its key short-term rate, banks have "no incentive at all to raise deposit rates," said Dan Fuss, manager of the Loomis Sayles Bond Fund in Boston.

That means investors who choose to dump bonds or stocks for the safety of cash will protect their principal — but won't be earning much on that money. The average yield on money market mutual funds remains a barely detectable 0.01%.

Bonds: The pain already is serious. Investors who got used to nearly perennial positive returns on bonds since 2000 are facing a harsh lesson in the basic math of fixed-income investments: When market interest rates rise, older bonds issued at fixed rates fall in value.

The average taxable bond fund had a "total return" of negative 1.9% in the first half, as falling principal value more than offset interest earnings, according to Morningstar Inc.

Bond losses deepened, at least on paper, after the June jobs report triggered another surge in market yields. The 10-year Treasury note yield, a benchmark for other long-term rates, ended Friday at 2.74%, up from 2.49% a week earlier and the highest since Aug. 1, 2011.

For many bond investors the issue isn't this year's still-modest losses, but the prospect that the U.S. could be heading into a prolonged rise in rates — after 30 years of mostly falling rates. (For a detailed discussion of bonds, see the accompanying story.)

U.S. stocks: The Great Rotation? Market bulls have long predicted that once the economy picked up speed, many investors would shift out of bonds and into stocks, in a so-called Great Rotation.

In June, however, some investors' initial response to the idea of an easing of Fed stimulus was to dump stocks. But the mood has turned positive again since then.

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