Prepare for Major Side Effects from the Fed's Epic Unwinding

Roughly 10 years ago, we suffered the largest slowdown in the U.S. economy since the Great Depression. Bear Sterns was given away at fire-sale prices, as was Countrywide Home Loans and many other banks in an epic financial meltdown.

The Federal Reserve found itself with the daunting task of stabilizing the economy and getting people back to work, and what would come next set the tone for investors for the next decade.The Fed provided bailouts for banks through the Troubled Asset Relief Program (TARP) and helped over-indebted mega companies like GM and Chrysler find a second life.

What’s more, they bought epic amounts of bonds on the open market to inject liquidity into the system, raise confidence, and stoke investment, growth and inflation. But that liquidity often just found its way into equity markets, and sayings like “Don’t Fight the Fed” and the “Bernanke Put” become popular.

All told, the Fed’s balance sheet swelled to $4.4 trillion, $4.2 trillion of which is classified as “Securities held Outright,” as part of the three rounds of QE. In comparison to the Fed’s total balance sheet assets, that number is staggering:

Source: Federalreserve.gov

The Fed wasn’t the only central bank to shift into overdrive, either. So bonds the world over became highly sought after. That pushed yields to record lows, and in some countries, into negative territory. That’s impressive, but what does it mean for us?

The great bond bull market was only briefly interrupted – in 2013 when we saw the “Taper Tantrum” and in 2015 when we saw a German bond market rout.

But this September, we’re expecting to get a plan for the unwinding, or selling, of those bonds on the balance sheet. Not all $4.2 trillion will be jettisoned. But a significant amount will be, and we’ll learn over what time horizon the Fed expects to make it happen.

That epic unwinding will have significant side effects in the markets. In fact, the process may already be underway.

Typically, the iShares 20+ Year Treasury Bond ETF (TLT, Rated “C”) goes up when the stock market suffers down days. But during the Fed’s QE programs, the TLT was biased to the upside even on days that stocks rose.

Now that the Fed is discussing paring down its assets … and Europe’s own bond buying stimulus plans are being called into question … that’s starting to change. TLT is underperforming even when the stock market is going down!

Next, as the epic QE unwind takes place, we can expect volatility to rise, and the complacency in this rally to dissipate. Stocks that provide “safer yields,” like utilities and telecoms, will likely go back to being laggards, rather than leaders.

We’ll also see increased stock differentiation, and money will flow into assets that benefit from rising rates like financials. When interest rates rise, industries that are sensitive to borrowing may see profits crimped, and their growth may slow. Others that depend on lending will see their margins increase, and as long as volumes remain stable or grow, profits will also follow.

So, the days of a rising tide lifting all boats will come to an end. Investors will have to do their homework to find quality stocks that feature the right combination of growth, momentum, and solvency, and that trade for reasonable prices. Since those are the kinds of characteristics the Weiss Ratings Model zeroes in on, it will be an invaluable tool to help you pick winning stocks.

Best,

Mandeep

Small Cap Edition, By Mandeep Rai, Senior Analyst Mandeep Rai has more than 15 years of investing experience, working as both a stock and credit analyst. At Weiss Ratings, he researches and evaluates financial and economic themes, and makes decisions on when to buy or sell specific shares for the Top Stocks Under $10 portfolio.