Watch the Fed in 2015

It’s not only what the Federal Reserve Board does that’s important to your money. It’s the words they use – or don’t use. Here, what you need to know

 

Keep a close eye on Janet Yellen this year. The chair of the U.S. Federal Reserve Board will probably have a greater impact on your financial fortunes than any other public figure. And it’s not just her decisions that will have a profound impact. It’s her words as well – or the omission of them.

Consider the word “patient” for example. In its latest policy statement, issued on Dec. 19, the Fed said that based on labour market conditions and inflation expectations it can “be patient in beginning to normalize the stance of monetary policy”. That was interpreted as meaning the governors are in no rush to raise the key federal funds rate from its current target of zero to 0.25 per cent. Stock markets rallied on the news.

But at some point, perhaps as early as the end of the first quarter, the word patient will disappear from the official statement. When that happens, expect all hell to break loose because it will be seen as a signal that higher interest rates are just around the corner.

How bad might it be? Think back to the spring of 2013 when then Fed chair Ben Bernanke talked about “tapering” the quantitative easing (QE) program. Yields spiked, knocking down bond prices. Interest-sensitive securities like REITs, utilities, and telecoms were battered. Income investors were left shell-shocked.

1. Avoid long-term bonds. They did surprisingly well in 2014 and so far in 2015 (up 4.56 per cent to Jan. 21), with Wednesday’s Bank of Canada rate cut adding to their gains. But their run may be close to over. When interest rates eventually start to rise (which they will) long bonds will be the most vulnerable to capital losses. Don’t abandon fixed-income securities because of the portfolio stability they provide but stay with short to medium term issues or funds that invest in them.

2. Buy U.S. Dollar securities. The loonie has been dropping for several weeks due to the steady decline in the price of oil. The Bank of Canada added to the downward pressure with its unexpected rate cut. An $0.80 loonie can’t be far away and it could fall even lower if the U.S. Federal Reserve Board raises its key rate. Any further drop in the loonie will add to your profits in U.S. Securities, whether bonds or stocks.

3. Focus on quality dividend stocks. High-yield securities will be especially vulnerable to any interest-based market correction that follows a hike by the Fed. Blue-chip stocks such as the banks should be less affected. In fact, higher interest rates are positive for the banks because they can increase the profit-making spreads on the loan rates they charge and the payouts they offer on deposit accounts and certificates.

4. Gradually lighten up on REITs. The Bank of Canada rate cut is a positive for the REIT sector, which took a big jump on the news. That’s great, for now. But when rates rise, REITs will likely be hit especially hard because they face a double whammy. Higher bond yields will force up REIT yields to maintain the risk premium, which means share prices will drop. At the same time, higher rates would add to the interest cost of the debt load that REITs carry on their properties.

Given the strength of the U.S. economy some economists suggest we could start to see changes in the Fed’s stance by mid-year and perhaps sooner. Personally, I think it will be closer to fall, but it’s best to be prepared. Check over your portfolio now and, if changes are indicated, start to implement them over the coming weeks.