I Want to Tell You an Important Lesson About the Federal Reserve

A landmark event happened this week.

No, I’m not talking about the first Super Bowl victory by the Seattle Seahawks. I’m referring to Monday’s swearing in for the new head of the Federal Reserve, Janet Yellen.

We don’t see the torch passed at the central bank very often. And frankly, this transition couldn’t happen at a more important time for the interest rate markets. Nor could it come at a time with more bad information about the Fed and monetary policy finding its way to TV and the Internet.

So I want to try to cut through the garbage and explain my take on where policy is going — as well as one of the most important Fed lessons I can share.

For starters, Yellen is taking the reins when Fed policy is undergoing an important shift. We’ve had 61 long months of rock-bottom interest rates, and so many rounds of quantitative easing that the Fed’s balance sheet has exploded to more than $4.1 trillion from less than $900 billion.

Janet Yellen is taking the reins when Fed policy is undergoing an important shift.

But beginning in mid-2013, the message out of the Fed began to change in subtle ways. Many on Wall Street failed to pick up on that shift, and many others are still trying to deny its impact.

If you just look around you, though, you can see the results everywhere. Just look at how the stocks and sectors most vulnerable to rising interest rates got hammered in the second half of last year.

Real estate investment trusts (REITs) finished the year roughly unchanged despite a surge of around 32 percent in the S&P 500. The Dow Jones Utility Index wilted in the back half of the year after a strong start.

And emerging markets — the ones that had previously benefitted from the surge of hot money into higher-yielding corners of the world — got crushed. The benchmark iShares MSCI Emerging Markets ETF (EEM) has lost so much ground, it’s basically trading for the same price as in mid-2009.

The turmoil has some predicting that the Fed under the dovish Yellen will soon cave, and start turning on the stimulus tap again. They’re saying the Fed will come to the rescue as it always has, and beat a hasty retreat from the shifting policy path it embarked on starting last spring.

But that brings me to the important lesson I mentioned earlier: Once the Fed shifts policy tacks, it’s almost never a “one-and-done” affair. Instead, these policy shifts tend to last for at least a couple of years, and involve multiple, repeated tightening steps.

My research shows the average “up” cycle for interest rates over the past few decades lasts almost 25 months. Not only that, but those cycles drive interest rates up by an average of 660 basis points (6.6 percentage points). Even if you strip out the massive late-’70s/early-’80s cycle, you see an average increase of around 400 basis points.

So it didn’t surprise me in the least when the Fed announced plans to taper QE by another $10 billion last week after lopping $10 billion off the program in December. That’s likely to be the norm for many, many months … followed by actual short-term interest rate hikes.

My advice: Gird yourself for those kinds of moves, and take appropriate steps to insulate your wealth … and build it.

Until next time,

Mike