Taper or No Taper, Here's How to Protect Your Portfolio

By Moe Zulfiqar

Will the Federal Reserve taper quantitative easing in September? This question has become the main topic of discussion among investors, since reducing or ending quantitative easing can have significant implications on the broad market. By the way, the Federal Open Market Committee (FOMC) meets on September 17 and 18. (Source: “Meeting calendars, statements, and minutes (2008-2014),” Federal Reserve web site, last accessed September 9, 2013.)

It’s no surprise that there is speculation. We are hearing some say the Federal Reserve will start to slow its purchases, and others are saying it won’t. It’s all becoming very confusing, to say the least.

Investors who are looking to invest for the long term need to first evaluate the situation by looking at what we know.

Last year, when the Federal Reserve started buying $85.0 billion worth of mortgage-backed securities (MBS) and government bonds, it said it would continue this operation until the unemployment rate hit 6.5% and the inflation outlook was 2.5%. (Source: “Press Release,” Federal Reserve web site, December 12, 2012.)

Where do we stand on unemployment and inflation?

Unemployment

The unemployment in the U.S. economy has certainly improved—if you look at the numbers on the surface, at least. In August, the jobs market report found that the unemployment rate in the U.S. economy was 7.3%, slightly lower from July, when it was 7.4%. Sadly, this is nowhere close to the Federal Reserve’s target; as a matter of fact, it’s running at more than 12% from its target. (Source: “The Employment Situation — August 2013,” Bureau of Labor Statistics, September 6, 2013.)

Inflation

According to the data provided by the Bureau of Labor Statistics, inflation isn’t robust, either. In July, the Consumer Price Index (CPI), an indicator of inflation, increased 0.2%, continuing its climb from June, when it increased 0.5%. In the first seven months of the year, the inflation in the U.S. economy has only increased 0.9%; clearly, the Federal Reserve isn’t winning on this front, either. (Source: “Consumer Price Index – All Urban Consumers,” Bureau of Labor Statistics web site, last accessed September 9, 2013.)

Going by all this, if we assume that the Federal Reserve will follow through with what it previously said, then the tapering on quantitative easing won’t begin in September.

On the other hand, when I look at the bond market, it seems that investors are already pricing in the slower quantitative easing and selling their bonds.

Since speculation began on when the Federal Reserve will taper, we have seen bond yields spike higher. Please look at the chart below of 30-year U.S. bonds. The bond prices have significantly declined in value, with the yields having gone from close to 2.8% in May to above 3.8% now.

Chart courtesy of www.StockCharts.com

 Taper or no taper, one thing has become very clear: the actions of the Federal Reserve have made the bond market risky. In the past few months, it has shown significant deterioration: bond prices have fallen and yields have spiked higher.

While some would say high yields are good at this level, you need to keep in mind that they are currently increasing—meaning that the bond prices are falling. Investors who are thinking about going into the bond market really need to consider this phenomenon. We haven’t even heard the exact dates from the Federal Reserve just yet.

If they are invested heavily in long-term bonds, it might be a good idea to take some profits off the table for the sake of capital preservation. In this case, investors should maybe consider moving their bonds towards the short maturities and then let the dust clear before making their decision.

This article Taper or No Taper, Here’s How to Protect Your Portfolio was originally published at Daily Gains Letter