What the Fed Might Do Next Year

Everyone on the planet who invests money is wondering if Ben Bernanke and his Federal Reserve cohorts have another off-script trick up their sleeves to wean the US capital markets and the economy from their $85 billion monthly deluges of free cash. One thing is certain – it has to end eventually, but when and how are sizing up to the biggest unknown in 2014.

Here’s the Fed’s problem in a nutshell. The stock and bond markets have become hyper-dependent on the large monthly injections of cash from the Central Bank. Stocks and bonds trade at values not supported by the lackluster economy as all the money from QE3 goes straight into stocks. The Fed bond buying program drives bond prices higher, and conversely, bond yields lower than current economic conditions warrant.

What happens when a big buyer in any market goes away? Prices come down right? They may come down fast like they did at the last Fed whisper of ‘tapering’ in June of this year. Everybody seems to be talking about the coming stock market declines, but what about the bond market?

When the Fed announces their taper, bonds and Treasuries in particular are due to get their comeuppance. They have been artificially propped up by the Fed for years and the loss of its buying guarantee will drive speculators out in a hurry, causing prices to dip (temporarily) below their economic trading norms.

When bond prices go down, interest rates go up. The first and most obvious casualty of the move will be the recovering housing industry. Mortgage rates could rise a percent or more. The fast increase will likely freeze a large portion of potential buyers in their tracks.

Now the Fed knows all this. They have some of the brightest economists on the planet working on the problem. So its fair to say they will more than likely not do exactly what the market expects. So what might they do?

Editor’s note: The following ideas have no basis in reported fact. They represent the opinions and ideas of the author alone.

Five Steps to Financial Sobriety

  1. Eliminate the 30-year mortgage. Private banks and markets don’t want bonds with such long maturities anyway. The 30-year is uniquely American and lately, it’s why our government is having such a hard time re-privatizing Fannie Mae and Freddie Mac. Just do away with the 30. Some home buyers who can’t afford the payments of a 15 or 20- year mortgage will be squeezed from the marketplace for sure, but in the long run the government would be doing many the favor of saving them from the scars of bankruptcy.
  2. Eliminate the 30 year Treasury too. Last time the Fed did it, demand drove the prices up, hence, long-term yields down. Keeping rates down on the long-end is a top concern for the Fed as they want to keep the housing recovery going.
  3. The Fed has announced they will hold mortgage bonds until maturity to avoid the coming losses. I suggest selling their longer Treasuries into any strength afforded by the elimination of the 30-year. Use that cash to –
  4. Buy short term 3-5 year Treasuries to keep the business borrowing rates as low as possible through the weaning period.
  5. End the dual mandate. While the Fed cannot end its own Congressional dual mandate to control the money supply and unemployment, they can parade the point before Congress and the American people until they/we get the message. It doesn’t work.

These points are pure fancy. There is little way of knowing what these smart economists will do next. Though it is almost certain that they will resist open discussion of any taper until after the Congress concludes its coming battles over budget and debt ceiling in February and March. It is also near certain that investors will experience the lion’s share of withdrawal pains from free-money addictions in 2014.

It’s time to come off the anesthesia and begin the real process of recovery.