How We Know the Federal Reserve Is in Control

This article was written with Oliver Pursche, co-portfolio manager of the GMG Defensive Beta Fund. It was part of a series of articles developed under an agreement with to work with a variety of contributors and assist them in delivering actionable investment ideas each week.

Plus, the one indicator to watch for a sense of where the market is going.

Over the past two months, the 10-year Treasury yield has climbed from around 1.75% to 2.75%. Consequently, mortgage rates have jumped nearly 100 basis points as well. Investors are rightfully concerned and asking how this will impact the economy and their portfolios.

So, have Ben Bernanke and the Federal Reserve lost control over interest rates? In my view, no.

I believe that the ongoing tapering talk is deliberate and designed to accomplish two things: one, establish a new trading range for rates and observe the markets and economic reaction to the rise in rates, and two, begin getting investors numb to the talk of tapering and rising rates so that when it does finally occur, the reaction will be muted.

With regards to the first point, consumer confidence and spending have not been materially impacted so far. Why? First and foremost, as a result of a still-rising stock market and rising home prices (both of which significantly impact “the wealth effect”), consumers are happy. Moreover, consumers have proven to be very resilient in the face of some of the changes in policy. This has been most visible in the fact that consumer confidence and spending continued to rise after the 2%-plus tax increase that resulted from the end of the payroll tax holiday earlier this year.

Similarly, to many observers’ surprise, the sequester – which began on April 1 – has not had a meaningful impact on overall spending. The bottom line is, despite various challenges and obstacles, consumer spending has stayed strong, most likely because of increased confidence in our economic recovery and pent-up demand for consumer goods and services following four years of self-imposed austerity.

I believe that consumer behavior is unlikely to change materially until there is a significant change in policy or economic outlook. For these changes, the key indicator I am watching is an increase in LIBOR rates. The reason? Most variable-rate loans — such as credit cards and home equity lines of credit as well as auto loans — have a relationship to LIBOR rates. As such, as long as the Federal Reserve and other central banks keep the Fed funds rate and other similar rates suppressed, we can expect to see LIBOR remain steady, ergo, we’ll see minimal economic impact.

With regards to the second point, I view the talk of tapering by Fed officials as the next step in the manipulation of markets and investor behavior. Think back to 2008, when the Federal Reserve and Treasury first mentioned bailing out AIG (NYSE:AIG) for the absurd sum of $80 billion in cash, plus another $65 billion in guaranteed loans, for a total of $145 billion — back then, an unfathomable amount. Since then, the government has gone on to “spend” nearly $700 billion on QE1, $1.2 trillion on QE2, an undefinable amount on Operation Twist, and probably over $1 trillion on QE3, aka, the current bond purchase program. And we are all numb to it – after all, what’s another trillion dollars? I expect Dr. Bernanke and other Fed officials to bring up tapering and the prospect of slightly higher rates in virtually every speech from now to year end (and most likely beyond) until investors and market participants stop reacting to the talk — and ultimately react in a muted manner to the actual tapering.

Despite all of this, some market sectors will benefit, and some will be impacted negatively. I believe the winners in a slow-growth, low-inflation, slowly-rising-interest-rate environment will be financial shares (tracked by the Financial Select Sector SPDR (NYSEARCA:XLF)), consumer discretionary shares (tracked by the Consumer Discretionary Select Sector SPDR (NYSEARCA:XLY)), and the aerospace and defense sector (tracked by SPDR S&P Aerospace & Defense (NYSEARCA:XAR)).

Conversely, sectors that are particularly sensitive to interest rates, such as utilities (tracked by Utilities Select Sector SPDR (NYSEARCA:XLU)) and real estate investment trusts (REITS) (tracked by SPDR Dow Jones REIT (NYSEARCA:RWR)) are likely to be underperformers.

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