The $2.7 trillion in Treasury bonds and $1.8 billion in mortgage securities the U.S. Federal Reserve built up in the wake of the 2008 financial crisis may have saved the banking system from collapse and spawned a bull market, but it has also had a profoundly negative impact on the financial lives of Americans.
Banks went on loan sprees, and consumers went on spending sprees. This period of easy money and low interest rates encouraged $1.4 trillion in student loans, $1.2 trillion in auto loans and $1.2 trillion in credit card balances—more than the total of all the troubled mortgage loans wiped out by quantitative easing.
On top of the excessive debt created by unprecedented low rates, retirees that relied on income from U.S. treasuries, CDs and money markets were forced to abandon this less-risky investment approach. Brokers selling variable and fixed annuities with promises of higher returns—and huge commissions and penalties for early withdrawal for unsuspecting buyers—came out of the woodwork.
Increasing the money supply also keeps the value of the dollar low. This makes investments, such as stocks, from a given country more attractive to foreign investors and also makes exports cheaper.
Now, the Fed is about to wreak havoc again by selling off its massive bond position. It stands to reason that when the likes of Citigroup, Wells Fargo, Goldman Sachs, etc. begin to transfer trillions of the selling proceeds from their accounts into Uncle Sam’s, it can have severe ramifications on the economy and the stock market.
Less money floating around the economy and a declining money supply may drive up rates that banks charge, damaging consumer confidence and putting the brakes on borrowing and spending. Back in 2013, when then Fed Chairman Ben Bernanke signaled a potential end to the post-crisis bond purchases sent the S&P 500 tumbling by 7.5 percent in a little over a month.
Of course, to add insult to injury, the Fed has already begun to aggressively tighten the monetary policy on its own, having hiked interest rates for the third time in as many quarters at the June 13-14 meeting.
If the mere prospect of higher interest rates makes the market nervous, just wait until the increases begin to snowball. That said, the Fed will have to handle the selloff situation delicately in order to avoid an uncontrollable rising of long-term rates capable of putting a stake in the heart of any economy or many market sectors.
The Fed’s plan is to initially sell about $6 billion worth of Treasury bonds and $4 billion worth of mortgage-backed securities per month, and gradually increase the amount it sells every month. It is expected to take between three and five years to get the Fed’s portfolio down to the targeted $2 trillion range, which would be equal to the amount of currency in circulation.
According to Moody’s Analytics, the unwinding of quantitative easing could push the 30-year mortgage rate past 6 percent within three years. Rising long-term rates have already put a dent in demand in the housing market.
The Fed bought $387 billion worth of mortgage bonds last year alone to maintain its holdings and is now the biggest buyer of U.S. government-backed mortgage debt, owning a third of the market.
Both the stock and bond markets have come to depend on the Fed’s programs — both the low interest rates and the balance sheet expansion — in these post-crisis years. Stocks, as measured by the S&P 500, have surged more than 250 percent since the recession lows, while interest rates have remained low across the spectrum.
But, all that is on the verge of reversing. In order to prepare for a change of guard in the future, you should take action to align you or your clients’ portfolios for growth and safety today.
For starters, the housing and real estate sectors are bound to take a beating so paring down these positions would be a good idea.
On the upside, the last time the Fed raised rates consistently came between 2004 and 2006 when the top-performing equity ETFs were in energy (XLE), utilities (XLU), telecommunication services (IYZ), financials (XLF), materials (XLB) and industrials (DJI).
A way to hedge against high interest rates is with niche bond ETFs.
Floating rate notes are investment grade bonds that do not pay a fixed rate to investors but have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of the issuers. Consider iShares Floating Rate Bond (FLOT) in this context.
2Another option is to tap bank loan ETFs like Highland/iBoxx Senior Loan ETF (SNLN). Senior or leveraged loans are private debt instruments issued by a bank and syndicated by a group of banks or institutional investors. It yields about 4.45 percent annually.
By investing in Proshares Investment Grade-Interest Rate Hedged (IGHG), investors can lessen rising rate worries through an interest rate hedge approach using U.S. Treasury futures. Since this fund targets a duration of zero, this could be an interesting play right now that yields about 3.34 percent annually.
We can’t forget about inverse bond ETFs for this scenario either. Barclays Inverse US Treasury Aggregate ETN (TAPR) looks to track the sum of returns of periodically rebalanced short positions in equal face values of each of the Treasury Futures contracts.
Finally, since both fears of a bubble in the market and the likely steepening of the yield curve may cause considerable moodiness, a low volatile and an ex-rate sensitive pick like S&P 500 ex-Rate Sensitive Low Volatility Portfolio (XRLV) could work well in this case.
The bottom line is not to ignore this next course of action by The Fed. Remember, any knee-jerk reactions from the stock market will happen in anticipation of an unpopular strategy or further rate hikes so waiting for details to come down the road could be costly.