Meet an expert Fed watcher who not only worked at the U.S. Federal Reserve but who also has suggested to the all-powerful central bank that there might be a way to exit the financial maneuvering known as quantitative easing.
Raymond Stone, co-founder of Stone & McCarthy Research Associates in Princeton, has an idea that the Fed may take seriously.
As most investors who pay close attention to stock and bond markets know, the Federal Reserve in 2008 embarked on a rescue mission to save our financial system from collapse. The Fed lent money at rock-bottom rates to pretty much any financial institution that asked, in the hopes of preventing bank closures, a run on brokerage houses, and even disaster for private insurers such as AIG.
For five years, the Fed has used a few tools: aggressively cutting interest rates, printing more dollars, and purchasing toxic assets from banks and quasi-governmental agencies, such as mortgages underwritten by Fannie Mae and Freddie Mac.
By 2012, the Fed had embarked on at least three rounds of quantitative easing (QE), in response to other pressures, such as the Eurozone crisis, while at the same time forcing investors out of low-yielding fixed income and into stocks and other riskier assets.
The Fed became a major investor in the U.S. bond market, and recently began buying an unprecedented $85 billion a month in bonds - meant to spur the economy to "preserve flexibility and manage highly unpredictable market expectations," the Wall Street Journal explained Friday. Currently, the Fed's balance sheet is roughly $3 trillion, compared with under $1 trillion as of January 2007.
The question now is, how will the Fed ease back on the QE measures without hurting the markets? Stone says there is another way besides "tapering off" and "managing expectations."
Stone explains: Fed officials plan to reduce the number of bonds they buy, varying their purchases depending on their confidence in the job market and inflation. The timing is hazy.
Stone's advice to the Fed: Don't sell.
"The fear [in the bond market] is that the Fed will taper off their buying program and then sell, and under that scenario interest rates will start going higher."
Without one of the biggest buyers - the Fed - in the Treasury and mortgage bond market, prices will start going down, and the government will have to start paying more interest to attract buyers.
Even worse, the Fed could then be selling into a falling bond market and suffer other losses.
Stone's idea is that the Fed holds the bonds it has bought until maturity. That could provide some stability to the system and wouldn't rock the markets. The average maturity of the Treasury bonds the Fed holds is 10.5 years, Stone estimates.
It sounds simple, and it might also buy the Fed time as the central bank faces a leadership change. Fed watchers' best guess for chairman Ben Bernanke's replacement is current Fed vice chair Janet Yellen.
While Yellen seems an obvious choice - she is a Democrat and an inflation "dove" - there are dark-horse candidates like Alan Blinder, who was vice chairman of the Fed in 1990s.
"My guess is Janet Yellen will become chair," Stone said. "She was president of the San Francisco Fed and would be the first woman chair of the Fed." Stone guesses President Obama might enjoy making a legacy pick.
"Yellen is the path of least resistance," agrees Guy LeBas, fixed-income strategist at Janney Montgomery Scott in Philadelphia.
What does it all mean for bond investors? Stone advises that while investors think bonds are safe, they need to be aware that rates rise and bond prices fall at the same time. And the Fed's moves could influence that.
For those unfamiliar with Stone, he was the director of global fixed-income and economic research at Merrill Lynch and an economist with Fidelity Bank in Philadelphia. He started his career in research at the Federal Reserve Bank of New York and was involved in analysis of international capital and trade flows and preparing briefings before Federal Open Market Committee meetings.