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If you've tried to calm someone down and instead had it blow up in your face, you know what it's like to be Ben Bernanke.
On Tuesday, the Federal Reserve chair and his Federal Open Market Committee tried to reassure investors that all would be well. What he succeeded in doing, however, was sending shivers throughout the markets about the unintended consequences of what the Fed might do next.
Is the worst-case scenario coming?
Coming just after the National Bureau of Economic Research declared that the recession had officially ended in June 2009, the FOMC statement threw cold water in the face of investors. Although the statement included a few modest signs of improvement in household and business spending, it highlighted the constraints on recovery, including a weak housing sector and continued contraction of bank lending. It also asserted with unusual frankness that inflation was at lower levels than the Fed is comfortable with and that the Fed could take steps that would directly promote higher inflation rates "at levels consistent with its mandate," including a continuation of its policy of reinvesting proceeds from its portfolio of securities.
Since the statement, financial markets have reacted strongly:
- Gold and other precious metals rallied sharply. The SPDR Gold Trust (NYSE: GLD ) ETF hit a record high yesterday as gold prices approached the $1,300 level. Several stocks related to precious metals, including Silver Wheaton (NYSE: SLW ) and Newmont Mining (NYSE: NEM ) , also rose to new all-time highs as higher metals prices could produce sustained profits going forward.
- Bonds responded to the threat of new quantitative easing from the Fed. Long-term Treasuries rebounded from their losses of the past month, and the Fed's inflation comments pushed iShares Barclays TIPS Bond (NYSE: TIP ) to two-year highs. Five-year TIPS are actually sporting negative yields right now.
- The dollar plummeted, as the Swiss franc climbed above the $1 mark to approach its 2008 record high. Even the euro, hit hard by the sovereign debt crisis, rebounded sharply to push the dollar index to a six-month low.
What is it about the Fed's statement that led to such panic in so many markets? The answer is less about what's happening now and more about what may happen in the near future.
Race to the bottom
Until the Fed's statement, optimistic investors could reasonably believe that the U.S. was helping to lead the world out of recession. Now, though, investors seem to have the same mind-set they did in late 2009: that the U.S. will be on the forefront of competitive currency devaluations while promoting inflationary policies and failing to focus on long-term fiscal restraint.
If you think that's the path the U.S. will take going forward, there are some things you can do to protect your portfolio.
First, be aware of your exposure to the U.S. dollar and take steps to hedge that risk. PepsiCo (NYSE: PEP ) and IBM (NYSE: IBM ) are two stocks that earn much of their revenue from overseas, nearly half for Pepsi and around 65% for IBM. A weak dollar actually helps them increase profits. On the fixed-income side, the CurrencyShares Euro Trust (NYSE: FXE ) and similar currency ETFs for a variety of different countries let you diversify your cash holdings while earning interest in line with local rates in those countries.
Second, weigh the chances of a global currency crisis. Fears of countries around the world encouraging inflation have underpinned gold and silver's recent advances, and record highs for precious metals haven't quashed hopes for further advances.
Finally, realize that even though bonds are moving higher, the threat of inflation is actually bad news for most bonds. With the exception of TIPS, any success by the Fed in stoking inflation would hurt bond prices going forward.
Face your fear
Bernanke and the FOMC gave a painful reminder that we still live in a very uncertain world, especially for investors. But that wake-up call is a good one if you take it as an opportunity to make moves that will protect your hard-earned capital.
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