Navigating the shift to a stingier Fed

After four years of providing trillions of dollars in cheap money to prop up the U.S. financial system and economy, the Federal Reserve has signaled that its generosity won't last forever.

On the face of it, that ought to be good news: It means the economy, and particularly the labor market, are getting healthier.

But as the last two months have shown, the transition to a stingier Fed isn't likely to be easy for global markets.

Stocks, bonds, commodities and currencies have experienced wild swings since mid-May, when the Fed began to hint that it was preparing to pull back on "quantitative easing," or QE — its program of pushing cash into the financial system via $85 billion a month in Treasury and mortgage-bond purchases.

Markets had another volatile day Friday, after the government said the U.S. economy created a net 195,000 new jobs in June, well above expectations. The report was further evidence that the Fed could look toward dismantling the economy's training wheels.

Stocks surged Friday, bond yields jumped and gold plummeted.

For investors, all of this points to the need for a new road map to guide the way in what may continue to be rough market terrain.

Here's a look at some of the most important issues investors need to understand as they think about their portfolios in the next chapter of the economy's recovery:

First, realize that it's early in the game — and a lot could change. The Fed hasn't committed to cutting back on its stimulus program; it has merely said it is "prepared" to reduce its bond purchases if the economy continues to look better.

Likewise, if the backdrop were to worsen in July and August, Fed Chairman Ben S. Bernanke could quickly signal that the central bank still isn't ready to take its foot off the gas.

But for now, many Wall Street pros are leaning toward the idea that the Fed this fall will begin "tapering" its bond purchases. Instead of buying $85 billion a month, it may buy, say, $60 billion.

"The Fed will indeed test the taper waters, perhaps as soon as September, and the financial markets will need to continue to adjust to a post-QE3 environment," said Scott Anderson, chief economist at Bank of the West in San Francisco.

Note that the Fed isn't yet talking about shutting off stimulus completely. But after becoming heavily dependent on the Fed's largesse since the 2008 economic crash, markets already are reacting even to the thought of less Fed money flowing into the financial system.

Cash still won't pay, perhaps for years. Investors hoping to earn more in cash accounts, such as bank savings certificates, will face more disappointment. Even if the Fed allows longer-term interest rates to rise by slowing its bond purchases, policymakers aren't planning to raise short-term rates soon from their near-zero levels.

In its post-meeting statement in June, the Fed said its rock-bottom benchmark short-term rate "will be appropriate at least as long as the unemployment rate remains above 6.5%." The June rate was unchanged at 7.6%.

Until the Fed raises its key short-term rate, banks have "no incentive at all to raise deposit rates," said Dan Fuss, manager of the Loomis Sayles Bond Fund in Boston.

That means investors who choose to dump bonds or stocks for the safety of cash will protect their principal — but won't be earning much on that money. The average yield on money market mutual funds remains a barely detectable 0.01%.

Bonds: The pain already is serious. Investors who got used to nearly perennial positive returns on bonds since 2000 are facing a harsh lesson in the basic math of fixed-income investments: When market interest rates rise, older bonds issued at fixed rates fall in value.

The average taxable bond fund had a "total return" of negative 1.9% in the first half, as falling principal value more than offset interest earnings, according to Morningstar Inc.

Bond losses deepened, at least on paper, after the June jobs report triggered another surge in market yields. The 10-year Treasury note yield, a benchmark for other long-term rates, ended Friday at 2.74%, up from 2.49% a week earlier and the highest since Aug. 1, 2011.

For many bond investors the issue isn't this year's still-modest losses, but the prospect that the U.S. could be heading into a prolonged rise in rates — after 30 years of mostly falling rates. (For a detailed discussion of bonds, see the accompanying story.)

U.S. stocks: The Great Rotation? Market bulls have long predicted that once the economy picked up speed, many investors would shift out of bonds and into stocks, in a so-called Great Rotation.

In June, however, some investors' initial response to the idea of an easing of Fed stimulus was to dump stocks. But the mood has turned positive again since then.

On Friday, major U.S. stock indexes rallied after the June jobs report. The Dow Jones industrial average rose 147.29 points, or 1%, to 15,135.84. That left it just 1.8% below its all-time high of 15,409 on May 28 and up 15.5% year to date.

Brian Belski, chief investment strategist at BMO Capital Markets in New York, believes that investors will increasingly see the prospect of less Fed stimulus as good for stocks, because it would suggest that the economic recovery can advance on its own.

"I see us heading into a generational shift into equities again," he said.

Others are far less confident about that. Gina Martin Adams, senior strategist at Wells Fargo Securities in New York, thinks it's unlikely that investors who are selling bonds will immediately switch to stocks.

"Typically when investors lose money they rotate out of riskier assets" altogether and go into cash, at least temporarily, Adams said.

What's more, she worries that investors may face disappointment as corporate earnings growth slows from a double-digit pace in recent years. Operating earnings of the Standard & Poor's 500 companies are expected to rise a meager 2.9% in the second quarter, according to Thomson Reuters.

If interest rates continue to rise, Wall Street will become much more focused on companies' fundamentals. Already, shares of companies that are highly sensitive to rising rates have been pummeled. The Dow utility-stock index, for example, has slumped 11% since April.

The market also still must overcome the deep distrust many investors have maintained since the 2008 crash.

Tom Burns, a 45-year-old sound technician in West Los Angeles, said his investment portfolio is 80% in cash. He has been reluctant to buy into stocks' rally since 2008 because "it feels like it's all fake," he said.

But market bulls see investors such as Burns as sidelined money that will eventually be lured back.

If bonds suffer losses and cash yields stay near zero, "People are going to have to warm up to equities," said Anthony Valeri, market strategist at LPL Financial in San Diego.

Foreign stocks: The Fed complicates tough times abroad. By signaling its readiness to reduce its massive financial stimulus program, the Fed is reinforcing the rest of the world's view that the U.S. economy is a relative island of prosperity.

The result may be to pull investors' capital into the U.S. from overseas.

Much of Europe remains mired in recession. China's economy has slowed markedly, as has Brazil's. Japan is trying to break out of two decades of deflation.

Stock market returns have been lousy this year in most of the world, apart from the U.S. The average European blue-chip stock is down 1.5% year to date. The Hong Kong market is down 8%. Brazilian stocks are off 26%.

The good news is that share prices are getting cheaper for long-term bargain hunters. And the European Central Bank and the Bank of England last week tried to kill off any concern that they would soon follow the Fed in cutting back on financial stimulus for their economies.

But the more encouraging view of America's prospects has driven the dollar to its highest level against other currencies since 2010. The danger is that a continuing rise could have three corrosive effects: making U.S. exports too expensive abroad; further devaluing foreign shares held by U.S. investors; and driving up inflation in emerging-market countries by devaluing their currencies (and thus their purchasing power).

Commodities: From bad to worse? China's economic slowdown has depressed demand for many commodities. Now they're facing another challenge: As the dollar grows stronger, commodities' allure as an investment alternative to the buck dims.

That has been most evident with gold. The metal has crashed from $1,800 an ounce in October to $1,212 now.

"It's over for gold," said Allen Sinai, head of Decision Economics Inc. in New York. "It's not a competitor for the dollar anymore."

Not every hard asset is in the same boat yet, however. Unfortunately for consumers, crude oil prices have been rising again amid the latest Mideast turmoil. On Friday, U.S. crude oil futures reached $103 a barrel, a 14-month high.

A final thought: Basic diversification never goes out of style. Even if markets get more volatile, investors who are in for the long run, and who keep a diversified mix of assets in their portfolios, may not feel any pressure to make major changes to their strategy.

That might include younger investors in so-called target-date retirement funds in 401(k) plans. In fact, for them, rising bond yields could mean higher returns over time as their funds reinvest in new bonds.

What's crucial is to avoid letting short-term volatility ruin your long-term game plan, said Kevin Gahagan, a financial advisor at Mosaic Financial Partners in San Francisco.

"We tell clients, 'We can make your portfolio less volatile, but let's be clear what the implication is for you,' " Gahagan said. Playing it overly conservative can mean "you're going broke safely."

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