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FED WATCHER SEES A THIRD WAY FOR EXITING QE Erin Arvedlund In our own backyard, meet an expert Fed

watcher who not only worked at the Federal Reserve but who has suggested to the all-powerful central bank that there may be a way out of the mess. His name is Raymond Stone, co-founder of Stone & McCarthy Research Associates in Princeton, N.J., and he has an idea the Fed may take seriously. As most investors who pay close attention to stock and bond markets know, the U.S. 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 private insurers like AIG. The Fed has over the ensuing five years used a few tools: aggressively cutting interest rates, printing more dollars, and purchasing toxic assets from banks and quasi-governmental agencies like mortgages underwritten by Fannie Mae and Freddie Mac. These tools were known as quantitative easing, and by 2012, the Fed had embarked on at least three rounds of QE, in response to others crises like the lack of confidence in the Euro, while at the same time forcing investors out of low-yielding fixed income and into stocks and other risky 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 economyin an effort to preserve flexibility and manage highly unpredictable market expectations, The Wall Street Journal explained on Friday. Currently the Feds balance sheet is roughly $3 trillion, compared with under $1 trillion as of January 2007. Now, how is the Fed going to ease back on the QE measures without hurting the markets? Stone says theres another way besides tapering off and managing expectations. Stone explains: Fed officials plan to reduce the amount of bonds they buy, varying their purchases as their confidence in the job market and inflation. The timing is hazy. Stone says his suggestion could work: dont 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 losses. Stones idea is that the Fed holds the bonds theyve bought until maturity; that could provide some stability to the system and wouldnt 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 Bernankes replacement is current Fed vice chair Janet Yellen. While Yellen seems like an obvious choice shes a Democrat and a dove, meaning not worried about inflation there are dark horse candidates like Alan Blinder, who was vice chair of the Fed in 1990s. My guess Janet Yellen will become chair, Stone says. She was president of the San Francisco Fed and would be the first woman chair of the Fed, he adds, a choice President Obama might enjoy making as a legacy pick. Yellen is the path of least resistance, agrees Guy LeBas, fixed income strategist at Janney Montgomery Scott in downtown Philadelphia. What does it 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 Feds moves could influence that. For those unfamiliar with Stone, he was the director of global fixed income and economic research at Merrill Lynch and as 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 prior to FOMC meetings. --enditall