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Portfolio Alert: Watch out for a Fed ease-up on Treasury buying

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The most recent data released from the Federal Reserve's Open Market Committee meetings show that the Fed remains relatively positive, albeit cautious, about an economic recovery in the U.S. This means that the Fed can start planning to wind down some of its debt buying programs including the its current program to purchase $300 billion in Treasury debt.

While the data was just released on Wednesday, the meetings actually took place on August 11th and 12th. But the results still merit scrutiny, especially for investors who may wonder what this could mean for their portfolios. Let's take a look.

First, why does the Fed buy treasuries? The Fed buys Treasury debt to try to bring down interest rates and to improve liquidity in the capital markets. When the Fed buys Treasury debt it increases demand for those securities. Typically, when demand for an asset increases so does its price. In this case, it is important to remember that when a bond's price increases its yield or 'interest rate' falls.

Over the last month Treasuries have enjoyed a nice bull market and as a result yields have been falling. However, what do you think will happen when the largest buyer in the market (the Fed) stops buying and starts planning to sell? The impact on prices could be significant.

A great way to visualize the impact of the Fed's buying activities in the treasury debt market is by looking at an exchange traded fund (ETF) such as the iShares Barclays 7-10 Year Treasury Fund (NYSE: IEF). The fund invests in treasury debt with seven to 10 years before maturity. The fund is up 1.5% over the last 30 days. It is even up nicely since the beginning of the financial crisis.

I think the Fed has been successful at keeping long term interest rates low by buying debt and injecting liquidity into the financial markets.

Of course, the Fed can't buy Treasury securities forever. When it stops, the impact of the change in strategy will be significant. The Fed has already announced plans to wrap up the $300 billion purchase plan by October.

To put this in some perspective, imagine what would happen if the largest institutional investor in a small stock stopped buying shares or worse, started selling them. How fast would the price of those shares decline? Could this happen to Treasury bonds?

A potential decline in bond prices matters to investors in popular bond ETFs such as IEF. But it also matters to stock investors. Assuming the Fed's actions reduce demand for bonds and remove liquidity from the market, this will drive yields up and increase the cost of capital for businesses. Increasing costs for businesses effects their bottom line, their earnings, and eventually their stock price.

Although in the long-term bonds usually fall in price as stocks go up, this normal relationship may be disrupted in the near term by the Fed's activity after October. Keep in mind that the U.S. Treasury itself will have to keep selling debt and increasing the supply in the market to fund the deficit.

How does this affect you? Essentially, if the increased supply from the Treasury and the declining demand and potential selling by the Fed drives down bond prices, yields and interest rates will probably rise. It's still very early in the recovery process. The concern is that interest rates could dampen corporate growth and stocks may flatten out or decline.

But this scenario also gives us plenty of opportunity as investors. Where bond ETFs fall, short traders (those who sell a stock hoping to buy it back later for a profit) make money. It is even possible to use bond ETFs that are inverse to bond prices. For example the Proshares Ultrashort 7-10 year Treasury ETF (NYSE: PST) is designed to return twice the inverse daily return of a 7-10 year treasury fund like IEF. Keep in mind, however, that FINRA has warned investors about using leveraged funds for anything but short-term positions.

For more conservative investors; when yields rise depositors get better returns and new Treasury bond purchases will come with a higher profit potential. A major shift in the balance between supply and demand in the Treasury market is not all bad news. Creating an investing plan to take advantage of those changes will make all the difference.

John Jagerson is a co-founder of Learning Markets.


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Last updated: November 26, 2009: 08:23 AM

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