Fed To End Quantitivate Easing

Probably the biggest thing the U.S. government has been doing to stimulate our economy in the wake of the 2008 financial crisis and recession has been something called "quantitative easing".  It is pretty much the practice of the Fed buying bonds from the Treasury to stimulate the economy.

Those bonds are sold to give our government more operating cash, to either pay bills coming due or spend the money on necessary services and/or projects that our leaders believe will be stimulative to the economy.  Sometimes, like I understand is the case now, the Federal Reserve actually prints new paper money with which to make the purchases.  The risk is inflation in the future, but such risk is taken with the intention that the short-term stimulus effects are worth the risk.

Now the economy is growing.  Slowly and not necessarily surely, but measurably and postively.  The Fed is thus in the middle of tapering the Quantitative Easing, creating a glidepath to ending QE (it had been buying $85 billion worth of bonds every month).

But last week one normally hawkish Fed big shot was surprisingly outspoken--and dovish.  He said the Fed would not necessarily end QE as planned, impying that the Fed would help the securities markets if need be (we were in a market decline last week, and he is thought to have been speaking to that matter with intent of reassuring investors)...  Word is, though, that most of his peers (including those with a vote on the matter, which I believe this one fellow does not have) intend to end QE for sure.

In short, the nFed is said to be on track to end QE, even if one of its members may have spoken his opion of what should be done instead of saying what the Fed will do.

Bill O'Grady (not Bill Gross--I cite each pretty often and want to be clear:  O'Grady is the global investment strategist/thinker, Gross is the manager of bond portfolios and mutual funds) writes today about this.  See the second and third paragraphs in the item linked here:  http://confluenceinvestment.com/assets/docs/2014/daily_Oct_20_2014.pdf

Okay, I wanted you to know the basics in case it is not clear.  I hope it helps.  Please contact me with any questions.  Thank you.

--Gary

Gary Partoyan

Potomac Wealth Strategies, LLC

(703) 746-8195 direct

Visit us online for helpful ideas and information!

Bonds Explained (briefly)

The Fed Funds Rate is at historic lows and interest rates will eventually rise.  That will cause downward pressure on bond prices.  Bonds, though, are usually considered the safer, more stable part of a diversified portfolio.  So, professionals and individual investors alike have bonds on the brain these days…

Bonds Explained, briefly:

1.       Bond investors are essentially making loans to companies, governments, and municipalities

2.       In exchange for their temporary investment (a few months on up to 30 years or more; mostly 1-10 years), bond investors are paid interest (usually monthly, sometimes just yearly, and maybe at other times).

3.       The longer the bond, or the riskier the bond, the higher the interest rate paid.

4.       Bond investors get their money back at the end of the term, in addition to interest; sometimes there is no interest paid ongoing but instead it’s included with the principal repayment at the end.

5.       If the bond issuer has financial trouble, bond investors may not get some or any of their money back; that's rare, though, even in the case of "junk bonds".

6.       It is complicated for individual investors to build and manage their own bond portfolios.

7.       High-net worth individuals and institutional investors can get much better pricing.

8.       Bond funds have costs that eat away at income and total returns, but there are several bond funds that have excellent cost-justification track records (I am constantly searching for and evaluating such).

9.       Bond funds, however, do not offer the actual return of investment; instead, bond funds have a "net asset value" (like a share price) that fluctuates indefinitely.

10.   So, there are trade-offs, and my professional opinion is that bond funds with excellent track records and consistent management are very suitable for most investors

Interest Rate Risk Explained, briefly:

1.       In short, bond prices rise when interest rates drop, and they decline when rates rise.

2.       That is because bond interest rates move up and down as the prevailing interest rates (fed funds rate, treasury bonds, etc.) change.

3.       Different types of bonds will move more or less with prevailing rates for various reasons.

4.       Bond holders can wait for their bond to mature and get 100% of their money back after already getting the interest rates promised.

5.       Bond prices, meanwhile, fluctuate as bond rates move because of the secondary market for bonds:

a.       You buy a bond today that pays 3% interest, but, when rates rise, someone else looking to buy a bond next year can get something similar to yours that pays a higher rate.

b.      If you want your investment back before the bond comes due, someone might be willing to buy your bond instead of a new one.

c.       But since yours has a lower rate than what they can now get, they'd only pay you less for your bond than they would for a brand-new one offering a higher rate.

d.      So, bond prices decline when interest rates rise.  Likewise, though, bond prices rise when interest rates fall.

6.       You might have a very safe and sound bond portfolio, but its value may fluctuate between the time you buy the bonds and get your money back.

7.       But holders of individual bonds do get their money back (plus interest already paid or included with the principal repayment at the end) if they hold to the end; that is, of course, unless the bond issuer goes bankrupt or has major financial trouble.

8.       Bond fund holders would have to ride-out the interest rate fluctuations and/or the bond fund managers would have to successfully adjust the portfolio in order to keep the fund's NAV going up (or from going down) in a rising-rate environment.

9.       Even if rates rise and bond prices fall, you can still make money (and keep getting interest income) from bond funds.

10.   The better bond funds have methodology and strategy that work well, and track records to demonstrate that.

11.   There are no guarantees that a great bond fund manager will succeed all the time, of course.

Bottom line:

1.       Bonds are not as safe as they usually are because interest rates are likely to rise.

2.       But bonds remain one of the three most important parts of any diversified portfolio.

3.       Portfolios of individual bonds are difficult for most individual investors to assemble and manage; bond funds have drawbacks but are good choices for many.

4.       Bond index funds have been touted for their low-costs and benchmark-matching performance (or close to it), but they pose increased risks in this likely rising-rate environment.

5.       Actively-managed Bond mutual funds offer a lot of advantages to individual investors—diversification, potentially cost-justifying performance, and convenience.

6.       I work hard to find and use only the best bond funds that are likeliest to perform well going forward.

7.       PIMCO is an example of a "active" bond fund manager that has an outstanding track-record

a.       While I have no obligation to keep using PIMCO funds (or those of other managers I favor), I expect PIMCO and some others will remain a key part of the bond portion of my Flex and Strategic portfolios.

What We Expect for 2011

I expect continued market volatility, for economic and political reasons.  This week's debt ceiling stuff is just part of the big picture that I think is already driving the ship.

Developed-market countries are laden with debt and suffering from declining, or no-better-than-anemic economies.  At some point, some major currencies could really devalue and the bond prices of the world's traditionally "best" economies could tank when the interest rates spike in the auction markets as they issue unprecedented amounts of new debt (via government-bond auctions) to fund their ongoing deficit spending.   The USA is not inherently exempt from this just because we're the greatest economic power in history.  Just ask the Romans and British about the notion of indefinite staying-power.

My best ideas for this year:

• opportunistic stock-picking (let's look at that--I like C, VCM, RIG, F, GM and some techies right now--seems they are under-valued and could skyrocket)
• opportunistic commodity bets (gold should go up, oil should go up, copper goes up especially if the USA recovers better than expected)
• global/emerging markets bond picking (as the Asian and other developing markets grow stronger, they can pay lower bond interest rates, boosting bond prices; and countries with rising rates, while posing risk to asset values, at least offer better income payments)
• dividend-paying stocks of high-quality, global companies are a great choice for income-oriented investors since quality bonds and cash alternatives are paying so little now

The big risk I fear, since all this macroeconomic knowledge is kinda baked into the cake, is China's efforts to slow down a bit to avoid the bad kind of inflation--if they over-do it and tank their economy, then it could lead to another global economic train-wreck and US bonds and dollar could go up suddenly.  This is unlikely, but staying nimble and diversified is nonetheless advisable.

 I still like my "Flex" portfolios for these reasons.  It is confidence-inspiring to have Dorsey Wright's Systematic Relative Strength strategy, Mssrs. Avery and Caldwell, and Mr. Cuggino running the opportunistic/unconventional stuff through their mutual funds, and all the more reason to have the Yacktmans and the Eveillard disciples picking our stocks, and Mssrs. Gross and Hasenstab picking our bonds.

How To Prepare For the Storm We Hope Won't Hit Us

With a new round of "quantitative easing" (printing new money so the Federal Reserve Bank can buy US Treasury Bonds that investors and China don't want to buy at such low interest rates) threatening to cause potentially crushing inflation, albeit while it is intended to fight-off looming near-term DEflation, Americans and others around the world are afraid.

Rightly so, as this could get ugly. It's a big storm brewing, but we don't know if it will hit us or pass us by. For those who want to prepare for it hitting us, here are some action items I recommend:

1) Make sure you have life and disability insurance enough to pay the bills for the family if you die or can't earn your living any more.

2) Pay-down or pay-off any credit cards and personal loans, including 2nd mortgages and HELOCs.

3) If you accomplish #2 above, then build-up cash reserves, preferably a year's worth of necessary family living expenses (food, shelter, transportation, health insurance and medicine, but no need to budget, in this case, for vacations and clothes and spa treatments).

4) If you have investments, diversify globally; 50% of your stocks/stock-mutual-funds should be investing in foreign developed and emerging markets, and same with your bonds/bond-mutual-funds.

5) To make #4 really work, do not use index funds or even traditional style-pure mutual funds; find global and flexible mutual funds with consistent management and outstanding long-term track records--the best among them were down only 25% or less during the 2008 40% market crash, and many were actually UP during the early-2009 market crash, and they have kept-up pretty well during the post-March 2009 market rally; these funds also often invest in currencies and commodities better than most of us ever could.

6) Be prepared to do radical things, like the adult children moving home, or the elderly grandparents moving-in.

7) Stay optimistic. There are some good signs. Ford Motor Company has made an astonishing turn-around, so other manufacturers can also.

8) Take prudent advantage of current low interest rates--re-finance your house and investment properties, buy that new car if you need to, consolidate debt you can't pay-off.

9) Make sure you have that cushion described in #2 and #3 above.

Helpful?

Re-Fi Updates

Progress. The lending industry is still a shambles, but it is at least opening up a bit.

One client owns an investment condo and wants to re-finance into a shorter-term and a fixed interest rate, even though it would cost him more money each month (giving up some cash flow to obtain more stability). The condo is worth twice what he owes on it, and it's more than paying for itself for many years now as an investment property. Still, earlier this year, he was just-plain rejected... "We don't do investment condo re-fi right now. Sorry."

Last week, though, the same person got some traction. "We can do that. The rate for investment properties is a lot higher than if you lived in the condo, and we can't let you take any cash out. But we can definitely re-finance it for you if you like the numbers we offer."

Not great, but progress, and I am trying to monitor the key economic signs for us.

What I'm Tracking Now--Interest Rates

I'm keeping my eye on interest rates. If they appear to be going up, we may need to adjust the bond portion of our portfolios, potentially rapidly and significantly.

Remember, bond prices drop when interest rates rise. Imagine fleeing the stock market for the bond market in order to preserve your nest egg, as millions of investors have done with zillions of dollars in recent years, only to have the nest egg reduced by bond prices dropping if/when interest rates rise? Pretty awful scenario, but also not unlikely to happen.

To defend against this "hurt even though I sought shelter" potential, we need to anticipate the interest rate moves.

If the Fed changes its language vis a vis fed funds rate, basically from the current "low for an extended period of time" to something like "for a while longer", that will have my attention.

If the newly-issued US Treasury bonds don't sell as much or as quickly at auction, indicating we might need to offer higher interest rates in order to "move the product", that will have my attention.

The Fed is unlikely to raise rates proactively until the economy is growing enough for inflation to become a concern. But rates may rise in the auction markets anyway, if our bond buyers (like China) determine that investing in the USA is more risky than usual. You see, they'll demand more for their investment, and we'll have to offer higher rates.

Either scenario will do damage to the net worth and account balances of investors positioned in the wrong kind of bonds or bond funds.

I seek to protect clients by keeping eye on what might cause the fire, not just by looking for clouds of smoke.

Bill Gross' Big Idea

Bill Gross, the "Warren Buffett of Bonds", is in the news this week. He has a radical idea to help "Main Street" and boost the economy.

In short, the tremendously successful billionaire, who runs what is the largest and, arguably, the best mutual fund in the country, wants Fannie Mae and Freddie Mac to lower the interest rates on all mortgages they hold now. Significantly. Like 6% loans would go down to 4%.

This would massively reduce the monthly payment obligations of the borrowers while still requiring they pay-back all of what they borrowed.

This would not require lenders to write-down the value of assets, either. They'd have to suck it up and plan on 1/3 less income, though.

Let me know what you think.

Troubling Signs: The No-Go Re-Fi

More signs pointing to economic trouble ahead... A client was rejected, flat-out, this week in two attempts to re-finance the mortgage on an investment property. Surprised? No. But this is not good news.

In short, the condo he bought as a bachelor is now an investment property he rents-out. It pays for itself, and then some, from rental income. It is also worth about twice what he owes on it. His credit rating is top-shelf, and his wife's is even better. They make enough money to do all the things they do, and they carry no debts other than their mortgages.

Nonetheless, he was rejected. The superstar mortgage broker he went to, who is one of the best salesmen you'll meet and a great guy, looked at his situation and said, "no dice." Then he went to Morgan Stanley Credit Corp, where the mortgage is right now. No dice--"we don't do any investment condos right now".

Folks, under Bush, and now Obama, Bernanke's Fed and Paulson's/Geithner's Treasury have flooded our economy with liquidity to get it going again. It comes in the form of actual money being sent out of government coffers, in the form of absolute rock-bottom interest rates, and in the form of regulatory adjustments. The intention is to spur the economy in the right direction.

It may well have prevented a Great Depression II so far, but it's not working beyond that. If this guy's own lender won't let him re-fi a loan that has a spotless record when he's in better financial condition than at the outset of the loan years ago, and when--get this--he was basically offering to pay them MORE money, something is not working. That's right, he wants to re-fi out of a 30-year loan and into a 15- or 20-year loan that would give them a higher interest payment from him each month. Since most mortgages don't last more than 5-10 years, it's arguably irrelevant that they'd normally rather have him for 30 years than for 15 years.

My point? Drop your politics and look at the reality on the ground. Whatever "They" have been doing so far is just not working. The economic activity in this country depends greatly on confidence and credit. When banks won't even make solid bets on existing customers who are willing and able to pay more, we're not yet back on track.

More On Interest Rates and Bond Investing

I'm preparing for rising rates. While I don't expect the Fed to raise 'em this year, or even in 2011, it is bound to happen some day. Rates are as low as they can go (the Fed Funds Rate is now 0-.25%).

There is also the market-forces factor. If the USA keeps needing to borrow money, our national credit rating could be at risk and that, along with the flood of additional bond issues to the global markets, could naturally force rates up, regardless of the Fed's action.

Well-managed bond "ladders" and bond mutual funds can mitigate the "interest rate risk" of owning bonds. Remember, bonds are usually less risky than stocks and are used for the more conservative and/or the income-oriented portion of an investor's portfolio. But rising rates hurt the market value of bonds, so portfolio values can decline when rates rise.

There are many ways to address these scenarios, and I have my ducks in a row. If we hit rough weather in the bond markets, we know where the lifejackets and life boats are, and how to use them.