What the End of the Fed's Buyback Program Means for Your Portfolio

The Federal Reserve is expected to end its quantitative easing strategy by the end of June. Many are worried that this will make bond prices drop. While it's possible, it's not a certainty. Let's see why.

Quantitative easing means the Federal Reserve tries to stimulate the economy by buying government bonds and other financial assets through newly created money, increasing the monetary base and banking system reserves. (It may also raise the prices of the financial assets purchased, lowering their yield.) This occurs when qualitative easing (the lowering of interest rates) hasn't proved sufficient and rates can't get lower.

Over the past several years, the Fed has implemented two rounds of quantitative easing, with the latest round expected to end next month. The conventional wisdom seems to be that with the end of the Fed's support to the bond market, the prices of Treasury (and other) bonds will surely decrease, and yields will rise.

Knowledgeable investors know not to make the mistake of confusing information with knowledge you can use to generate market-beating returns. Unless you're in possession of inside information, the market has already incorporated what you know into prices. Certainly, the end of QE2 has been well publicized. Thus, that information is already embedded in prices.

Here's another way to think about the outlook for yields. The end of QE2 is a tightening of monetary policy. Thus, it could be seen as reducing the risk of inflation. That could reduce both the expected inflation rate and the risk premium for unexpected inflation, leading to lower yields and higher prices for nominal bonds.

The conventional wisdom also seems to be that QE2 is also a negative for the stock market. One objective of an easy monetary policy is to entice investors to take more risk, helping both the bond market and the stock market. However, investors could decide that the Fed's decision to end QE2 was taken because the Fed now has more confidence that the economic recovery is now self sustaining and no longer needs its support.

As always, my crystal ball is cloudy. As Casey Stengel supposedly said "Forecasting is very difficult, especially if it involves the future." And the evidence shows that there aren't any good forecasters. That's why Warren Buffett concluded that market forecasts tell you nothing about the market but a whole lot about the person doing the predicting.

The prudent strategy remains the same as always, maintain the discipline of adhering to your investment plan.

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