There is a hand in your portfolio you may not be aware of. In fact, there are 12 hands: those of the 12 members of the Federal Reserve and the Federal Open Market Committee, the Fed’s monetary-policymaking body.
“Investors need to understand the power of this entity,” says Karissa McDonough, chief fixed-income strategist at People’s United Wealth Management in Burlington, Vermont. “The Fed’s in the driver’s seat and we’re just along for the ride.”
The Fed is the puppetmaster behind the economic curtain, pulling the strings that control our monetary environment and, by extension, our portfolio returns. The good news for investors is it’s a sheer curtain; if you pay attention, you can use the Fed’s actions to guide your portfolio to higher returns.
Build a Fed policy rotation strategy. It’s hard to overstate the degree to which the Fed has impacted stock market returns, McDonough says. Co-authors Gerald R. Jensen, Robert R. Johnson and Luis Garcia-Feijoo studied this effect in their book, “Invest with the Fed: Maximizing Portfolio Performance by Following Federal Reserve Policy.” Says Jensen, a professor at Creighton University in Omaha, Nebraska: “It amazed us how strong the patterns were between Fed actions and what happened in the financial markets,”
He and his co-authors developed a rotation strategy that overweights securities in five of the highest-performing asset classes during each monetary environment. Backtested for the years 1970 to 2013, their Fed rotation strategy yielded a portfolio value more than 40 times higher than that produced by the Standard & Poor’s 500 index. That translates to a $10,000 investment in 1970 growing to more than $32 million by 2013, compared to $786,205 in the S&P 500.
They’re in the process of developing an exchange-traded fund that will follow this rotation strategy, so stay tuned, Jensen says.
[See: The 10 Best ETFs to Buy for 2018. ]
Their strategy used two of the Fed’s favorite strings to pull as indicators for when to rotate: the discount rate, or the rate the Fed charges banks to borrow money, and the federal funds rate, or the rate banks charge each other for short-term loans. The Fed’s website lists both of these rates.
A decrease in the discount rate and the fed funds rate signals the Fed is moving into an expansive, or easy, monetary policy. In such environments, asset classes such as small-cap value stocks and discretionary sectors tend to outperform, Jensen says. This is because when interest rates are lower, it’s easier for businesses and individuals to borrow capital, enabling companies to grow.
The Fed can also stimulate growth by purchasing U.S. government bonds from banks, thereby providing banks with more money to lend to consumers. More money in consumers’ hands means more discretionary spending. The more people spend, the more the economy grows. “Everything that we’ve experienced in terms of crazy equity returns and incredibly low bond returns [in this bull market] is a direct result of all the liquidity that the Fed is pumping into the system” by keeping interest rates low and purchasing Treasurys, McDonough says.
On the flip side, as Bill Martin Jr., Fed chairman between 1951 to 1970, once said, the Fed is also tasked with taking the punch bowl away before the economic party gets out of hand. The Fed does this by raising interest rates, making capital harder to borrow or by selling bonds in the open market, all of which take cash out of the system.
When the Fed tightens its purse strings, a restrictive, or tight, monetary environment is said to be taking place, with asset classes such as commodities and emerging markets tending to outperform, according to Jensen and his team.
[See: 7 Emerging Market ETFs to Buy Now.]
Why would the Fed want the party to end? Because too much fun can lead to inflation and even asset bubbles. Likewise, when interest rates stay low too long, people may “try to create funky structures to pump up yields,” McDonough says, such as by packaging subprime mortgages into tranches and marketing them as low-risk, high-yield investments to yield-hungry investors.
Use the yield curve to predict recessions. If you think the Fed didn’t play a part in the 2008 financial crisis, think again. “People tend to focus on the symptoms and not the cause” of the financial crisis, says Jay Hatfield, portfolio manager of the InfraCap MLP ETF (ticker: AMZA) and InfraCap REIT Preferred ETF ( PFFR) in Manhattan. “The symptom was the mortgage market blew up and Lehman Brothers went bankrupt,” but the cause was the Fed’s monetary policy.
The Fed created the yield-hungry monster by keeping interest rates at historic lows in the early 2000s. When the Fed changed course and began raising rates in 2003, mortgage rates spiked and home prices fell until homeowners could no longer afford the mortgages they never should have qualified for in the first place.
The Fed is the most important indicator for bear markets and negative investment returns, Hatfield says, because its actions dictate the yield curve, a graph that plots the yields of similar-quality bonds across various maturities. In a normal environment, short-term bonds will have lower yields than long-term bonds to compensate investors for the risk of locking their money up for a longer time. This creates a nice, upward slope for the yield curve
When short-term rates are higher than long-term rates, however, the yield curve forms a crescent shape and is said to be inverted. A recession has followed almost every yield curve inversion in the past 100 years, making an inverted yield curve one of the most reliable indicators of an impending recession, Hatfield says.
When the Fed raised short-term rates in 2006, the yield curve inverted. An investor who was watching the Fed in 2006 could have saved himself some pain by being more conservatively positioned entering the recession, Hatfield says.
The yield curve had been flattening throughout 2017, but the slope began to increase recently, suggesting the threat of a recession is receding a little. You can view the current yield curve on the U.S. Treasury Department’s online Resource Center.
Forecast future rates by following the dot plot. For a better idea of where we might be heading, look at the Fed’s dot plot, Hatfield says. The dot plot is a graph of each of the FOMC members’ projections of future targets for the federal funds rate. Currently, the majority of those projections call for a targeted rate of about 3 percent in 2020, with two Fed governors believing it should be north of 4 percent. The Fed publishes a revised dot plot on its website after each FOMC meeting.
[See: 10 Investing Themes to Remember for 2018.]
Although the dot plot can help you gauge the Fed’s future policy, keep in mind it’s only an estimate and not a definitive sign of what rates will do. The important point is that “if you think the Fed is just some esoteric bunch of grey-bearded guys sitting in a room, it’s not,” McDonough says. “But they still move markets.”
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The Fed’s Critical Role in Your Portfolio originally appeared on usnews.com
