The Biggest Market Risk For 2014Author: John MasonLast Updated: January 2, 2014 “The biggest risk for 2014 is definitely the risk of the Fed getting it wrong.”This quote, published in the Financial Times, is from Didier Saint-Georges, an investment committee member at Carmignac Gestion, one of Europe’s leading asset management firms.The Federal Reserve is on an exit trajectory from its third round of quantitative easing. The foundation of this third round of quantitative easing has been the Fed’s purchase of $85 billion of Treasury securities and mortgage-backed securities every month.Two earlier Federal Reserve attempts to get away from a policy of quantitative easing resulted in a reversal of the effort to exit the policy and a return to another round of the quantitative easing. Thus, it is not assured that the Fed will, in fact, be able to continue to pursue the current exit strategy.The reason why officials at the Federal Reserve are so reluctant to move away from quantitative easing is two-fold. First, these officials are very concerned about the weakness of the economic recovery taking place in the United States. Since the beginning of the Great Recession in December 2007, Fed Chairman Ben Bernanke and the Open Market Committee of the Fed have made it very clear that they were going to err on the side of too much monetary ease during the downturn and recovery. A replay of the Great Depression of 1929-1933 and the follow-up depression in 1937-1938 was not going to take place on their watch.The second reason had to weakness of the American banking system. Commercial banks have continued to be under-capitalized and still hold troubled assets. The Federal Reserve has supplied massive amounts of liquidity to the banking system in order to keep problem banks afloat so that, with the help of the FDIC, troubled banks can be closed or acquired by healthier banks in a calm and smooth atmosphere. This effort was also aimed at encouraging the economic recovery and preventing a “double-dip” recession. Still, the United States banking system is still losing about 200 individual banks per year.Federal Reserve officials postponed the introduction of the current exit policy until its December meeting because they were waiting until the economy and the banking system showed enough strength to warrant a reduction in securities purchases.However, the Fed is still determined to err on the side of too much monetary ease rather than too little if the economy still looks to be too frail. So, it is not completely certain that the Federal Reserve will continue to exit a quantitative easing program.Even if the Federal Reserve continues to reduce the quantity of monthly security purchases, a great deal of uncertainty exists with how this “exit” will be accomplished and how the “exit” will impact financial markets.The reason for this statement: The Federal Reserve has never conducted an exit like this before!Fed officials were on unknown ground as they worked through the recession and into the subsequent recovery. They did things that had never been done before. But, in attempting to err on the side of too much ease, the perceived major consequence of excessive monetary ease was the possibility that price inflation would be rekindled. In the near term, however, this seemed to be less of a danger than letting the economy slip into a deeper and even more damaging recession.On the other hand, the “tapering” of security purchases represents a tightening of Federal Reserve policy. And, making monetary policy more stringent is scary.Some people, including some Fed officials, have argued that the Fed is not really tightening up on monetary policy. Instead of buying $85 billion in securities each month, these people claim that reducing purchases to $75 billion each month still represents a very expansive monetary policy.The analogy I use to explain my concern is this: the Federal Reserve is driving a car that is going 85 miles per hour. Those driving cars behind the Fed can also drive their vehicles at 85 miles per hour and everything can be OK.However, what happens when the Fed slows down and begins to travel at 75 miles per hour. Some can argue that the Fed is still going at a very rapid speed. But, to those who had been traveling behind the Fed car at 85 miles per hour must now step on the brake and slow down to 75 miles per hour to avoid a pile-up. A “tapering” of the speed means a slowdown to everyone following behind.Now let’s turn to the bond market. If the Federal Reserve is now on an strategy to continuously reduce the amount of securities it purchases every month, how will this impact the yields in the bond market…especially yields in the longer-term end of the bond market?People who have read my LearnBonds posts before know that I don’t believe the Federal Reserve has a great or lasting impact on the yields of long-term US Treasury bonds. There may be some liquidity effects of the Fed security purchases in the short-run, but if we are talking about 5-, 10-, or 30-year bonds, the conclusion I draw from my research efforts is that Fed actions do not have a lasting impact.As I have written, I believe that the very low, long-term bond yields of the past several years has been a result of massive movements of funds leaving a Europe in financial distress seeking a “safe haven” investment…which was found in the United States. One result of this massive movement of funds was the extremely low level of yields on inflation adjusted Treasury bonds (TIPS). The yield on the 10-year TIPS security reached a NEGATIVE yield of almost 100 basis points in 2012 at the height of the financial upheavals in Europe. As the financial situation in Europe has become more positivethe yield on the 10-year TIPS has risen through zero and recently hovered around a POSITIVE 80 basis points.It is my feeling that the yield on this TIPS will continue to rise as more and more funds leave the US and return to Europe. This yield should rise to a level consistent with the longer-term rate of growth of the economy. Combining these two effects, I think the yield on the 10-year TIPS will go to around 1.5 percent in 2014. The Federal Reserve will not have much influence over this rate.The inflationary expectations built into the nominal yield on the 10-year Treasury security is around 2.2 percent. Note that this is the expectation for long-term inflation and not the expectation for inflation over the next year or two. The Federal Reserve does not have much influence over this measure because it is a market-determined rate.Thus, I believe that the yield on the 10-year Treasury security should rise to the 3.5 percent to 3.7 percent range in the coming year…if there are no other major upheavals during 2014.Here, however, is where I get back to the quote that began this post. The biggest risk for 2014 is the Fed getting the “exit” wrong! The Fed has never done such a “exit” before and there is a lot that could go wrong! We are talking here about “unknown, unknowns.” I expect longer-term interest rates to rise in 2014, but…other than saying that…we will just have to wait and see what happens. That is what major uncertainty…risk…is all about.About John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.