America’s Shrinking Deficit: Get Positioned For The Taper

Ben_BernankeETF Base:  The Fed’s bond buying spree is the largest central bank action ever. Its reversal, and eventual exit, will be even bigger.

Recent data point to the fact that the Fed can and should slow or cease its purchases of Treasury and mortgage-backed securities.

America’s shrinking deficit

Believe it or not, the monstrous American deficit of 2009 is no more. In the 2013 fiscal year, the deficit will shrink to 4% of GDP according to the Congressional Budget Office. That’s down from 10.2% in 2009 and 7% just last year.

To be fair, the government has some help. Interest paid to the Fed from U.S. Treasury bonds and MBS investments is returned to the U.S. Treasury. The Fed returned $91 billion to American coffers in 2012. After making $85 billion bond buys each month in 2013, the Fed’s payments to the U.S. government will only grow larger for this year.

Meanwhile, the GSEs, Fannie Mae (OTCBB:FNMA) and Freddie Mac (OTCBB:FMCC) are in the conservatorship of Washington, D.C. After rewriting the rules to steal the GSEs from equity holders in 2012, all cash flows from Fannie and Freddie go straight to government. The GSEs wrote checks totaling more than $66 billion just this year.

Either way you slice it, the shrinking deficit enables the Fed to think seriously about an end to the taper. Arguably, rising rates may be marginally more impactful to employment given that many more people are willing to retire at interest rates of 5-6% rather than rates of 0%.

Smart moves to make

The Fed’s taper has direct and indirect consequences. An end to easy money will reduce liquidity for the riskiest of assets, which is why junk bonds have been a poor performer since rates ticked up in May. Indirectly, an end to quantitative easing will increase the cost of capital – interest rates are going higher.

Besides moving your money out of rolling bond funds and into target maturity funds, or going into insurance ETFs, investors should consider also the banking sector.

In 2012 I laid the case that bank stock ETFs would continue their 2012 rally into 2013 based on rising net interest margin and new loan volume.

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