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Here’s why I’m betting against the Fed’s decision to unwind economic stimulus

  • The Federal Reserve just announced it is going to start paring down its massive $4.6 trillion balance sheet.
  • John Rutledge says the Fed really doesn't understand the pain it has just unleashed on the economy and the market.
  • His investment strategy will be to bet against the Fed's anti-QE program.

The Federal Reserve announced this week that it is going on a crash diet. For nine years, the central bank binged on bonds in the name of quantitative easing (QE) to push down interest rates and stimulate the economy.

Now, in order to shrink its bloated $4.5 trillion balance sheet, the Fed will liquidate $10 billion of securities each month. After 15 months they will have lost a total of 450 billion pounds, er, dollars, and weigh in at just a tad over $4 trillion.

The best part: The Fed says the diet will be painless. They say they can do the whole thing without selling a single security by simply allowing securities to "roll off" as they mature!

Call me a skeptic but I know two things about losing weight. 1) No diet is painless. 2) What really matters is whether you stay with the program for the long-term, which is really hard to do. It's no different with monetary policy.

The Fed's announcement amounts to switching from the largest extended money-printing exercise in history to the largest extended money un-printing exercise in history. Neither they nor we know exactly how it is going to work because it has never been done before. But we do know the numbers are huge. And the net effect on the economy is pain -- higher interest rates, lower growth, lower stock and bond prices. The question is how long they will stick with the program as the pain level rises. Here are a few things to think about:

First, shrinking bank reserves is absolutely necessary. I know of no example in history of a central bank printing this much money without prices sooner or later rising roughly in proportion. Printing money inflates asset prices first. Accordingly, QE has produced big increases in stock, bond and property prices. It's impact on wage rates, incomes, and goods and services prices has been much slower, the puzzle Janet Yellen was referring to when she said "Our understanding of the forces driving inflation is imperfect." But unemployment is low and labor markets are very tight, prompting the Fed to begin Project Un-QE before final goods prices accelerate.

"Shrinking the Fed's balance sheet is not going to be as painless as some say .. "Not reinvesting" is no less painful that outright selling. And the pain could be substantial."

My logic for tightening now is different — in my view the Fed is targeting the wrong inflation rate. The real damage done by inflation is that it undermines capital formation by forcing people to hold the wrong assets. Investors' most important decision is how to divide their portfolios between tangible assets like real estate and financial assets like stocks and bonds. It is the inflation rate of tangible assets, not inflation measured by the consumer price index (CPI), personal consumption expenditures (PCE) or any other basket of consumer goods that matters for interest rates and capital formation because rising real asset inflation induces people to shift portfolios away from financial assets. This pushes stock and bond prices down, raises interest rates and the cost of capital for new investments, and undermines capital spending and long-term growth.

Looked at this way, inflation is already well over the Fed's 2-percent target. According to the latest existing-home-sales report, the median price of an existing home increased 5.6 percent over the past year. A person buying property with a 20 percent down payment and a 4 percent mortgage rate would earn a 12 percent annual return on their equity, significantly higher than the 6 percent to 8 percent expected return on stocks or the 2 percent return on Treasurys. Put another way, the real interest rate that matters — the difference between the rate of return of a real asset and the financial asset you would have to sell in order to acquire it is negative.

Shrinking the Fed's balance sheet is not going to be as painless as some say. It matters not a whit whether the Fed shrinks its balance sheet by selling a bond or by collecting the principal of a bond that is maturing. Either way, the person on the other side of the transaction writes a check to the Federal Reserve, which reduces the stock of bank reserves by exactly the same amount. "Not reinvesting" is no less painful that outright selling. And the pain could be substantial. At the $50 billion per month maximum the Fed announced today, the Fed would have to sell bonds every month for 3-5 years.

How today's "data-driven" Fed reacts to that pain is the silver dollar question. My guess is their tolerance for slower growth, rising unemployment, rising interest rates and falling stock prices will be limited. For that reason, my investment strategy will be to bet against the Fed's anti-QE program by increasing exposure to commercial real estate and commodities, by opting for long-term fixed rate financing, and by keeping fixed-income maturities very short.

Commentary by John Rutledge, the chief investment officer at Sanafad, a global principal investment house. He is also a senior research fellow at Claremont Graduate University, where he teaches complexity economis and finance. Follow him on Twitter @johnrutledge.

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