The Federal Reserve has been very accommodative. Its goals are very simple: it wants economic growth in the U.S. economy. As a result, the Federal Reserve is taking extraordinary measures, printing $85.0 billion a month and using it to buy U.S. bonds and mortgage-backed securities (MBS). The hope is that the money will go to the banks, which will lend it to consumers who then spend it, leading to economic growth.
Sadly, the problems continue to persist in the U.S. economy, leaving economic growth still far from sight. The techniques used by the Federal Reserve aren’t working: the unemployment rate continues to be staggeringly high, troubling trends have formed, and the inflation continues to be low—threats of deflation loom.
Given all this, one would assume there might be something else that the Federal Reserve can do. Unfortunately, instead of using different measures to fight the problems in the U.S. economy, the Federal Reserve is planning to keep on doing what it has been doing for years now. I believe the techniques used by the Fed will continue on for some time.
Here’s my reasoning: in a testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, the newly nominated chairman of the Federal Reserve, Janet Yellen, said, “We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession. Unemployment is down from a peak of 10 percent, but at 7.3 percent in October, it is still too high, reflecting a labor market and economy performing far short of their potential. At the same time, inflation has been running below the Federal Reserve’s goal of 2 percent and is expected to continue to do so for some time.” The Federal Reserve realizes the problems still remain, but no other solution was provided. (Source: “FRB: Testimony—Yellen, Statement before the Committee on Banking, Housing, and Urban Affairs—November 14, 2013,” Board of Governors of the Federal Reserve System web site, November 14, 2013.)
If the Federal Reserve continues to print money in the form of quantitative easing, don’t be surprised to see more of the same—key stock indices will head higher and bond yields will continue to decline.
But what happens when the Federal Reserve starts to put the brakes on its asset purchases? We saw a minor episode of it in May; the bonds market witnessed a very noticeable sell-off. This time around, I wouldn’t be surprised if the sell-off is much bigger.
Dear reader, you have to keep in mind that the Federal Reserve became a massive buyer of bonds. Its balance sheet is huge, and closing in on $4.0 trillion. If it sells the bonds it has, the bond yields will go high, and if it keeps them, the current money printing will result in higher inflation ahead.
So, how does one actually profit from the actions of the Federal Reserve?
As long as the Federal Reserve continues to print money, investors may be able to profit from exchange-traded funds (ETFs) like the iShares 20+ Year Treasury Bond (NYSEArca/TLT). Essentially, this ETF buys long-term bonds, so as the Federal Reserve continues to buy bonds, their prices will continue to go higher, and investors will profit.
Once the Federal Reserve moves away from its money printing, ETFs like the ProShares UltraShort 20+ Year Treasury (NYSE/TBT), which shorts long-term bonds, will be able to provide investors with profit.