How to Increase Your Profits as Monetary Policy Tightens

The verdict is in…

The Federal Reserve will taper further. In its statement, the Federal Reserve said, “Beginning in April, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $25 billion per month rather than $30 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $30 billion per month rather than $35 billion per month.” (Source: Board of Governors of the Federal Reserve System web site, March 19, 2014.) The Federal Reserve has been tapering quantitative easing since January by $10.0 billion each month, coming down from $85.0 billion a month in December. 

To us, it will not to be a surprise to see the Federal Reserve taper further. If this becomes the case, then in just five months, there will be no quantitative easing. The printing presses will stop. 

This doesn’t bother me. It’s all too known and expected. 

With this taper announcement, the central bank also provided its projections on where the federal funds rate—the rate at which the Federal Reserve lends to the banks—will go. It said the rate can increase to one percent by 2015. By 2016, this rate can go up to two percent. Mind you; the federal funds rate has been sitting at 0.25% for some time now—since the U.S. economy was in the midst of the financial crisis. 

What happens next? 

Economics 101 tells us that when interest rates increase, bond prices decline and bond yields increase. 

Quantitative easing and low interest rates have caused more harm than good. These two phenomena caused the bond prices to rise and yields to decline to historically low levels. As the Federal Reserve tapers its buying and looks to raise the interest rates just next year, U.S. bonds may face some headwinds. 

Rising interest rates are a bond’s worst enemy. 

Please look at the chart below of the 10-year U.S. Treasury note yields, paying particular attention to the time at which the Federal Reserve released its statement about the most recent taper and interest rate guidance (circled area). Investors rushed to sell their bonds. The yields on 10-year U.S. Treasuries increased significantly—in just one day, they rose more than 3.3%. 

 

                     Chart courtesy of www.StockCharts.com 

This sell-off in the bonds can very well be the case going forward. As the Federal Reserves starts to taper and looks to increase interest rates—bond prices will decline.

 

Those investors who are looking to profit as the Federal Reserve moves from easy monetary policy to tighter monetary policy should look at exchange-traded funds (ETFs), like ProShares Short 7-10 Year Treasury (NYSEArca/TBX) or ProShares UltraShort 20+ Year Treasury (NYSEArca/TBT). These ETFs essentially short the U.S. bonds, which will fall victim to the tightening of monetary policy.

 

This article How to Increase Your Profits as Monetary Policy Tightens was originally published at Daily Gains Letter