As Investors Await Fed to Act, Focus Is Not Just On Rates

As the Federal Reserve begins backing away from a range of stimulus programs, investors have a lot more to keep an eye on than interest rates.

The Federal Reserve headquarters in Washington, DC.

Until now, the markets focused almost exclusively on what the central bank would do with its benchmark federal funds rate, the interbank rate that heavily influenced other interest rates.

But with the Fed preparing to ease up on its massive program to pump liquidity into the financial system, the old rules no longer apply. And that's made investors nervous.

"This time around there's so many different moving parts that the markets could stay on edge throughout this whole process," says John Canally, economist for LPL Financial in Boston. "What constitutes a tightening? The markets are already uncertain. The Fed is another uncertainty, another wall of worry that the market's going to climb."

Perhaps the biggest change is that the Fed will no longer use the federal funds rate to steer monetary policy. Instead, it will focus on the rate it pays banks for money deposited with the central bank—the so called rate on reserves.

But the Fed also is preparing to stop buying mortgage-backed securities and it will begin easing its purchases of other debt securities. That will have a major impact on the pricing of those securities—and the mortage rate homeowners will pay.

For now, Fed Chairman Ben Bernanke is trying to keep markets calm by sticking with his "extended period of time" language in reference to near-zero interest rates.

In remarks released Wednesday, Bernanke gave further hints about the Fed taking away the proverbial punch bowl—but did not discuss a timeline. Investors remain skittish over the looming changes and stocks have vacillated in the past two sessions despite a continuing procession of improving economic news.

"The only thing that matters has been six words—'exceptionally low for an extended period,'" says Lawrence Creatura, portfolio manager at Federated Clover Investment Advisors in Rochester, N.Y. "When that verbiage changes, that is the signal that some of the specifics will begin to be unleashed."

As the Fed gets past the talking stage and into the action stage, the market reaction could be pronounced.

To be sure, though, tightening from the Fed might not be a bad thing; the removal of liquidity measures in fact would signal the economy is strengthening after a crippling recession.

"Bernanke will perhaps be faced with the task of removing the punchbowl before the guests arrive," Creatura says. "These actions may not be taken in response to vibrant economic recovery but in contrast to restore confidence."

Investors will be left to sift through the central bank's actions and decide how to proceed after a wild market run-up that saw US stock indexes surge about 60 percent.

The building consensus has been that the easy money from last year is over and that investors this year will have to watch the Fed's actions—in addition to the usual myriad market-moving dynamics—and proceed with caution.

The move in the early part of 2010 has been toward big balance sheet, dividend-paying, large-caps and away from the low-quality market movers of 2009.

"Our central that a rising rate environment is going to force investors into an incrementally more selective investment process," Nicholas Colas, chief equity strategist at ConvergEx, wrote in a note to clients. "This will result in a back-to-basics style of investing, with an eye for quality managements, clean balance sheets and stable business models.

"The dash-for-trash of 2009 is largely over, in our opinion, and the flight to quality has just begun."

Changes in investor sentiment come even though the Fed by most accounts has been consistently transparent, with a steady stream of statements indicating that even if tightening isn't just around the corner, it is coming.

Bernanke Outlines Exit Strategy

Following the Tuesday release of Bernanke's remarks that he was supposed to make the Congress—the testimony was cancelled due to inclement weather—some analysts speculated that the first rate hike could come in March, and might be as high as half a percentage point, or 50 basis points.

That in itself could contrast with the more tepid moves often taken by Bernanke's predecessors.

"The market actually liked the fact that they did 25 basis points every single time in 2004 and 2005," Canally says. "I don't think they're going to do that this time. I think they're going to do a couple 50s and see what happens. That might cause turmoil."

Investors are preparing portfolios with strategies to go both long and short the market and to use a variety of strategies in other assets.

"We're going to see a lot of stops and starts through the year, a lot of volatility," says Kevin Mahn, chief investment officer at Hennion & Walsh in Parsippany, N.J. "They really need to challenge themselves to consider a wider range of asset classes and sectors to get involved with."

One investment drawing increased attention is the US dollar, which could grow if the Fed is consistent with tightening policies—and doesn't get outdone by competing central banks across the globe that also likely will be adjusting their own monetary policies.

"We've had a long-dollar position anticipating that this kind of thing would happen in 2010," says Brett D'Arcy, CIO at CBIZ Wealth Management in San Diego, Calif. "What you will likely see is strong-dollar, strong-market. Increases in interest rates can always create volatility for stocks. If they're being increased because the economy is improving domestically, that should be good for equities and the dollar."

The challenge for Bernanke will be to make sure that the Fed takes away its programs in a way that doesn't shake the markets too much.

"Bernanke is going to be walking a very difficult tightrope," Creatura says. "But he's going into it with his eyes open rationally and is doing what he can at this stage."