The U.S. Federal Reserve is one of the most closely watched elements of the global financial system, and for good reason.
This powerful central bank has the ability to stimulate economic growth — both real and imaginary — and influence the overall power of America’s currencies on the world stage.
There are plenty of times when the Fed helped get the American economy out of a bind and its actions were ultimately a net positive for investors. Consider the unconventional monetary policy decisions immediately after the financial crisis, which had never been tried before and undeniably helped stabilize a very fragile banking system here and overseas.
But of course, the Fed doesn’t always get things right.
Sometimes, when it takes extraordinary measures to help fight a crisis, that often means that it needs to take equally extraordinary measures to wean the U.S. economy and financial system off its stimulative measures — and if it fumbles the handoff, the downturn it was looking to avoid can wind up actually being much worse.
Consider the early days of the Federal Reserve, when the central bank tried to use monetary policy to counteract a downturn that began in the 1920s. Inflation was rampant after World War I, with prices high and investments moving out of the country. The Fed raised rates to try and get in control of the situation but the shock was too much, and America’s gross national product slid by more than 20% from 1920 to 1921 — a deeper downturn than the Great Depression, if not quite as long.
On the flip side, there also were the missteps of the Fed in the 1970s during “stagflation.” The central bank focused primarily on stimulating the economy and keeping rates down — but as most economists now understand, that only made the inflation problem worse. At its peak, inflation hit a 14% annual rate — and even after it receded, businesses and consumers remained reluctant to spend, and unemployment soared to double digits.
There are plenty of other examples, too. But what’s important in 2018 isn’t necessarily the history of past Federal Reserve actions, but rather what the current body is doing.
And, of course, how these policies will affect your portfolio.
Elite investors know how to find profit opportunities in any market. But even they will admit that there is a lot to be said for hedging your bets with tactics that offer insurance against volatility and widespread market declines.
As the Federal Reserve continues to dramatically change its monetary policies from crisis-era stimulus efforts to a more “normal” level, it is worth looking at asset classes that may be affected most — and how investors can protect themselves.
So What Is the Fed, Exactly?
Most people know there is a Fed, and that it can affect interest rates. But there are many misconceptions about how it operates and where its power truly lies.
Here’s a brief rundown of what the Federal Reserve is — and what it is not.
The Fed Is a System, Not a Single Bank
The Federal Reserve is, in fact, 12 regional banks that collectively operate as the nation’s central banking system. There is no single bank or lender at the top, which both decentralizes power to prevent manipulation and localizes the work of each regional bank to monitor the needs of its “local” businesses with more nuance. The Fed is like the media — a collective body made up of many independent actors. But also like the media, it is very possible for there to be a shared opinion across multiple institutions that is simply not correct.
The Chair Is Not “In Charge,” But Wields Tremendous Soft Power
Just as one Federal Reserve bank doesn’t set policy, no one official is running the show. Yes, the chairman Jerome Powell is the executive who must report to Congress on Fed policies twice a year just like his predecessor Janet Yellen did. And in the modern era of heightened scrutiny after the financial crisis, the chair also is the public face of the Federal Reserve System who holds press conferences.
But while chairpersons do set meeting agendas and determine how economic issues are prioritized, they have only soft powers and are not true executives. Rather, they are a first among equals on the board; the chair is similar to the chief justice of the Supreme Court — with the ability to sway opinion if it’s at a tipping point, but no way to unilaterally change things.
Similarly, the Fed’s comments are never guarantees and they are notoriously veiled in ambiguity. However, increasingly it is the words and guidance of the central bank that matters most to investors. The actual policy and voting all take place after the fact.
The Federal Reserve Is Independent
This may rub some conspiracy theorists the wrong way, but the main governing body to oversee the Fed system is the Federal Reserve Board of Governors. This body is made up of seven members appointed by the president of the U.S. and confirmed by the Senate. But after that, Fed governors are appointed to 14-year terms. This is, once again, similar to the independence provided to a Supreme Court justice and a way for policymakers to stay true to their principles and training instead of beholden to the political whims of the day.
It is highly unlikely that there is such a pervasive conspiracy about manipulation of currency or markets across this many people, across so many years, without us hearing about it. Remember, insider trading on Wall Street is far from uncommon — but to date, there has yet to be a big scandal around rate-rigging or front-running the Fed. It simply is too big an organization, moving too slowly and through too many people, for there to be an easy and predictable way for a small group to influence it for their own specific ends.
The Fed Has No Duty to Help Savers
Those who have derided the Fed over the last few years liked to say that it “punished savers.” But that’s not entirely fair. The Fed simply had no loyalty to savers, because it’s not supposed to according to its structure.
The purpose of the Fed, according to most economists, is the “dual mandate” created in 1977 via an amendment to the Federal Reserve Act. That amendment dictates that the Fed “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” That balance between modest inflation and low unemployment is, in essence, the purpose of the Fed — not to make sure your savings account yields 5%.
Much of the focus since the financial crisis has been on the “maximum employment” part of that mandate, which has meant lower interest rates.
Bankers Set CD and Bond Rates — Not the Fed
The idea of the Fed “raising rates” on loans or savings accounts is easy in concept, but it more complicated in practice. What the central bank is actually doing is increasing the Federal Funds Rate.
This is a specific interest rate that depository institutions like your local bank will use to lend their reserves to each other overnight, on an uncollateralized basis. As you can no doubt surmise, those reserves are held at the U.S. Federal Reserve — but that’s where its role ends.
But how does that trickle into bonds or other rate-sensitive markets? Well, because those reserves are a building block for the entire financial system.
For instance, if you walk into your local credit union and need a $1 jumbo million mortgage or small business loan, they may not have an extra liquid $1 million laying around that day. So they borrow it on a very short-term basis from a peer, and repay it in short order. But if that peer is going to charge 1.75% on that short-term loan instead of 0.25% — respective rates for today vs. rates two or three years ago — then the bank that’s actually conducting business with a customer may choose to pass some of that expense on. So a 3.0% mortgage may become a 4.5% loan.
Similarly, if reserves can be costly to borrow and lend to other institutions with a modest rate of return, banks are incentive to keep more cash in their bank accounts. So they try and entice depositors with higher CD rates — happy to pass on an extra 50 or 100 basis points in their quest to build up a cash cushion.
So What’s Trade?
All this is admittedly a bit complicated. But it’s important background to help you understand that the Fed has no direct influence on a specific rate on a specific product.
That is a crucial sticking point because it allows institutions and investors to profit by targeting areas where policy is changing and inefficiencies are there to be exploited.
Step #1 – Seek Out “Unconstrained” Bond Funds for Income
Most investors know there is an inverse relationship between interest rates and bond values. That’s pretty simple to understand since a new Treasury bond yielding 3.0% is more attractive than the exact same bond issued six months ago and yielding just 2.7% or 2.6%.
However, that is an oversimplification of the bond market. Yes, a plain vanilla bond fund like the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) lost ground across the first few months of 2018. But an exception to this rule that bond funds fall in a rising rate environment are active funds, where a wise manager can focus on specific areas of opportunity — such as emerging market debt, junk bonds or even just plain cash for stability — instead of being stuck an the obviously bad bonds that are dictated by a rigid index fund like TLT.
One unconstrained ETF worth considering is Virtus Newfleet Multi-Sector Bond ETF (NYSEARCA:NFLT) which delivered a small return across the first three months of the year, without even accounting for any of the income from its holdings. That’s no mean feat in a rising rate environment.
If you aren’t tied to exchange-traded products and favor a conventional mutual fund, consider Calvert Absolute Return Bond Fund (MUTF:CUBAX), which also was up slightly in Q1 and has outperformed its aggregate bond benchmark significantly over the past three years of central bank tightening.
Step #2 – Shorten Your Bond Duration (or Hold to Maturity) for Stability
Of course, if you’re in bonds more out of a desire for capital preservation than significant income generation, you may not mind leaving a little yield on the table in exchange for reducing your risk of volatility.
One tactic to avoid sensitivity to interest rates is to rely on shorter-term bonds that mature fast enough that interest rate changes don’t matter as much. Consider that while the aforementioned long-term TLT treasury ETF lost significant ground in Q1, its sister fund the iShares 1-3 Year Treasury Bond ETF (NYSEARCA:SHY) was effectively flat.
Of course, you don’t get as much yield this way. Currently, iShares 1-3 Year Treasury Bond ETF’s 12-month trailing yield is just 1.1% and its current distribution yield has ticked up to just north of 1.3%. That’s the obvious trade-off for an investor who wants to limit downside risk but still needs income.
Another alternative, however, is simply to hold individual bonds to maturity. A bond fund loses value only because it sells some older investments on the open market and purchases new ones, but there’s nothing that says a bond has to ever be sold before it matures. Much like a 30-year mortgage, when you enter into an agreement with a specific corporation or government entity on a loan, the terms are fixed. So if you’re content taking the nearly 3.0% yield in 10-year Treasury notes and locking that in, go right ahead.
The downside is that in a rising rate environment, 10-year bonds may yield 3.1% or 3.2% in a matter of months. But if you want stability and certainty, that may be a wise trade-off for your portfolio.
Step #3 – Rely on Cash-Rich, Credit-Worthy Blue Chips
Moving on to stocks, investors need to be careful of any holdings that are dependent on constant borrowing at sub-par credit ratings. Because as rates rise, so does the cost of capital — and for many struggling companies, an extra few million in debt service each quarter could mean serious pain.
Look at troubled brick-and-mortar retailer GameStop (NYSE:GME) as one good example. The company has been offering three-year debt at around 6.7% interest. That’s the equivalent of a “payday loan” for a corporation! In a rising rate environment where bond investors demand big premiums for risky debts, it’s not unrealistic to expect GME to be entertaining double-digit yields in a year or two.
It’s a lose-lose, where either GameStop gets the money and pays out the nose for it… or it can’t find a lender, and has to cut bone deep to make ends meet.
On the flip side, a company like Microsoft (NASDAQ:MSFT) or Johnson & Johnson (NYSE:JNJ) is a slam dunk. These are the sole two AAA-rated corporations in America right now, and boast billions in cash reserves on top of their top-notch credit profiles. There is zero risk that these firms will have access to the money they need to grow, buy back shares and pay dividends to investors for many years to come.
Step #4 – Buy Gold
I’m not naïve enough to think that gold is truly a “safe haven” asset. Just look at the last several years and you’ll see plenty of volatility, with sustained declines from about 2012 to 2015. Nor do I think it’s at all realistic that gold will ever be used widely as currency, despite what some hysterical pundits may say.
But if you’re looking for an uncorrelated asset to the equities market, gold does have a lot to offer as a hedge because it is incredibly independent of stocks.
For those unfamiliar with the vagaries of correlation, if two assets move completely in sync in the same direction they will show a “correlation coefficient” of positive 1.0 and if they always move in opposite directions they will show a correlation of -1.0. A correlation reading of zero means, obviously, there is no correlation and the assets move independently.
While different time periods admittedly yield different results, over the last three years gold has had a correlation coefficient of roughly negative -0.15. A perfect zero correlation is all but impossible in the real world, so gold may be as close as you can find to an asset that is independent of the stock market this year.
Whether you buy gold in physical bullion or invest via an ETF like the popular SPDR Gold Shares Trust (NYSEARCA:GLD), the end result is the same — an asset that is independent of the stock market, and thus a way to swim upstream or hang tight even if things sour for equities in 2018 or 2019.
Step #5 – Consider Downside Insurance
Of course, there’s no guarantee that a rising rate environment is the right thing for the U.S. economy or the stock market. There’s also no guarantee that even if it is, we won’t see a boatload of hurt for equities and bonds alike in this time of transition.
So just as you purchase car insurance or homeowner’s insurance, consider protecting your nest egg with an investment that will profit if all hell breaks loose.
These can be inverse funds like the Direxion S&P 500 Bear 1X Shares (NYSEARCA:SPDN). this ETF holds futures and short positions on S&P 500 stocks in an aim to deliver the opposite results of the index. For instance, if the S&P 500 goes down 10% it will go up about 10%. The drawback is that if stocks rally strongly you will actually lose money as this ETF goes in the opposite direction — that’s what “inverse” means, after all. However, you may want to consider those losses simply as the cost of insurance against a crash instead of a trade.
There are also hedge-fund-like instruments out there, such as the AdvisorShares Ranger Equity Bear ETF (NYSEARCA:HDGE) that makes hand-picked bets against stocks it expects to suffer more than its peers. for instance, the fund has bet strongly against social media company Snap (NYSE:SNAP) since its IPO for obvious reasons, and actually turned a nice profit in Q1 by betting against specific companies even though the market itself was up. This is a more flexible way to hedge than a downside fund like the SPDN that is broad-based on the entire S&P 500, but keep in mind you are at the mercy of the managers and what they choose to bet on rather than simply riding broad market trends.
Remember, these investments are sometimes seen by aggressive traders as profit centers. But low-risk investors may also benefit from the peace of mind that comes with a modest bet against the market as a form of insurance.
Think of it this way: If you have a $100,000 portfolio and put 5% of that in a downside fund, that’s just $5,000. And if the market never crashes but instead rallies 10%, you would see opposite returns — or a 10% loss, for $500 in total declines. To many risk-averse investors nervous about the Fed right now, that seems like a very small premium to pay for a form of insurance against a steep crash in stocks.
