U.S. savings bonds  © Corbis,  SuperStock

I think the Federal Reserve is setting up investors for a significant change in policy to be announced after Wednesday's meeting of the Fed's Open Market Committee.

The new plan would resume the rapid growth of the Fed's balance sheet and push it to $3 trillion sometime in 2013.

And that would make the big problem facing the Federal Reserve and the U.S. economy even bigger. After expanding its balance sheet by buying what will soon be an additional $2 trillion in debt to help stave off the worst effects of the global financial crisis and then to support a stumbling U.S. economy, how does the Fed shrink its balance sheet back to something like normal size without crashing the U.S. and global economies?

The Federal Reserve's Operation Twist is scheduled to expire this month. That program to swap about $270 billion in short-term Treasurys for longer-term, five- to seven- year debt in order to lower long-term interest rates – to support the recovery of the housing sector and to stimulate economic growth -- is almost certain to end with the year.

But Fed Chairman Ben Bernanke and company are also almost certain to replace Operation Twist with a new, more aggressive program of quantitative easing. The fallout from this will be new pressure on bonds that could eventually send investors fleeing -- and those who aren't careful will get hurt in the rush.

A new buying binge

The Fed is clearly worried that the debate alone over the fiscal cliff -- or worse, the actual expiration of all of the Bush tax cuts, the Social Security tax reduction and extended unemployment benefits, plus the automatic budget cuts imposed by the debt-ceiling deal -- could slow the economy and even send the U.S. back into recession.

Recent speeches by Federal Reserve governors and basic math all suggest the new program  will be an out-and-out plan to buy five- to seven-year Treasurys. That would continue the thrust of Operation Twist but get around a big problem the Fed now faces: It has become increasingly  difficult for the Federal Reserve to sell its short-term holdings of Treasurys and to buy medium-term debt to replace them because the Fed has effectively sold most of its short-term holdings.

The new program would require the further expansion of the Federal Reserve's already massive balance sheet, which stood at $2.85 trillion as of Nov. 21. That $2.85 trillion level has been relatively stable since June 2011.

The new plan would change that. The number floating around Washington and Wall Street mentions Fed buying of about $45 billion in Treasurys a month. That would easily push the Fed's balance sheet to more than $3 trillion sometime in 2013.

Amazingly enough, the Fed's balance sheet was at just about $1 trillion before the start of the current downturn.

The Federal Reserve's most recent plan for shrinking its balance sheet goes back to 2011. Then, the Fed projected that it might start selling off some of its holdings of Treasurys and other debt in mid-2015. That, if you remember, is also when the Fed might begin raising the short-term interest rates that it directly controls. Recent announcements from the Federal Reserve's Open Market Committee have promised that the Fed would keep short-term rates at their current 0% to 0.25% level until at least the middle of 2015.

Logically, this plan made some sense: If the economy was strong enough by mid-2015 to withstand the downward pressure of higher short-term rates, it should also be strong enough to face some selling by the Federal Reserve of its medium-term debt portfolio.

The science of printing money

Why does all this matter? It all goes back to the why and how of the Federal Reserve's manipulation of its balance sheet to begin with. By buying Treasurys or other debt in the open market, the Federal Reserve stimulates the economy by adding to the money supply and lowering the cost of money (by lowering interest rates). At least, that's the theory behind the Fed's programs as the economy struggles to pick up speed after the Great Recession.

The Federal Reserve pays for these purchases, essentially, by creating money with the government's printing presses. That's why its purchases of bonds in the open market add to the money supply -- those purchases are paid for with newly printed money. Seen from this perspective, the Fed's balance sheet consists of "assets," such as Treasury bonds, purchased with money conjured out of thin air.

The big problem comes when the economy starts to pick up speed. Then, all that created money that was intended to speed up growth becomes the source of inflation and threatens to push up not just prices (consumer inflation) but also the prices of financial assets (asset-price inflation). Neither is good. The Federal Reserve has a clear mandate to fight consumer-price inflation because rising prices eat away at the value of money, making the fixed returns on things like bonds less and less valuable and reducing the value of paychecks, too. Once the expectations of future inflation become ingrained, the rate of inflation can soar as everyone tries to raise prices or increase wages faster than the rate of inflation.

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The Federal Reserve purports to be concerned with asset-price inflation, too -- although in practice, the central bank has been reluctant to check asset-price inflation before it produces bubbles like the ones in the technology sector of the stock market in 1999 and 2000, or the more recent bubble in housing prices.

I'd assume -- I'd like to assume -- that after presiding over the inflation and bursting of two financial market bubbles, the Federal Reserve would be determined not to let the expansion of its balance sheet produce a third bubble that would again devastate the U.S. economy. Hence the plan for an exit in mid-2015, and hence the worry about adding to the balance sheet that must be unwound.

My worry -- about the financial markets and the Federal Reserve's effect on them -- focuses on what appears to be an extraordinary complacency in the bond market.

The coming battle of bonds

Bond investors know we're looking at higher interest rates in the future which, like inflation, bring down the value of bonds. Yet money continues to pour into the bond market, and interest rates remain at astonishingly low levels. The assumptions by many investors seems to be that 1) rates could go even lower on some combination of global uncertainties that maintain the U.S. role as a safe haven, and that 2) smart investors (which, of course, always includes the individual bondholder in question) will be able to get out before rising interest rates and/or inflation inflict real damage on bond portfolios.

In this calculation, I worry that bond investors are putting too much confidence in the Fed's promise to maintain short-term interest rates near their current 0% to 0.25% range until at least the middle of 2015.

The Federal Reserve does indeed directly control short-term rates, and the central bank probably can deliver on that promise.

But the Fed doesn't directly control medium- or long-term interest rates, and those rates could well start upward while the Fed is still engaged in a quantitative program designed to lower rates and even before the Fed starts to unwind any part of its balance-sheet expansion.

Looking toward the Fed's previous goal of beginning to reduce its balance sheet by selling bonds in the open market in mid-2015, it's only logical to ask:

  • When will traders begin to sell their bond holdings in anticipation of that move?
  • When will they start to demand higher interest rates in compensation for greater uncertainty in Fed policy?

Getting ready for the bond washout

So what do you actually do? I think you have enough lead time to put some strategies in place. 

First, I think you watch for signs of increasing expectations for rising interest rates. I think the interest-rate turn will be apparent first in the market for three- to seven-year Treasurys, and so these are the early warning signals you should watch.

Second, I think you re-evaluate your recent assumptions about asset classes, returns and risk. Bond returns have killed stock returns during this period when extraordinarily low rates have led to even more extraordinarily low rates. I don't think you can just assume that's the way the financial universe will work over the next 10 years.

Third, if you need income to meet your goals and needs, I think you have to broaden your search parameters. Pimco bond guru Bill Gross has moved into emerging-market debt, particularly that of Mexico, for example. Closer to home, potential changes in tax rates have dampened the enthusiasm for dividend-paying stocks because of the possibility of a big increase in rates as a result of negotiations over avoiding the fiscal cliff. One day, believe it or not, Congress will actually make a decision and remove a great deal of the uncertainty surrounding tax rates on dividends. At that point, I think you'll start to see the large gap between yields on Treasurys and other bonds, on the one hand, and dividend stocks, on the other, start to close. It's amazing to me that shares of Chevron (CVX) yield 3.4% when 10-year U.S. Treasurys yield 1.6%. Which would you say has better management -- Chevron or the United States? Which is more likely to raise the payout on existing bonds or shares? Which has the better balance sheet and which is more likely to see a credit-rating downgrade?

Fourth, I think it's safe to assume that the Federal Reserve will not be able to manage short-term interest rates, medium-term rates and a reduction in the size of its balance sheet without some occasional disruptions. Laying in a few fear-and-chaos hedges -- gold is the easiest -- comes to mind as a reasonable strategy for any portfolio.

And fifth, I think you can bet on a decline in the U.S. dollar for one of two reasons:

The Federal Reserve can't manage this balancing act and has to keep its balance sheet bigger than it desires for longer than it wants -- thereby raising more worries among overseas investors about U.S. financial management.

The Federal Reserve manages to find the extraordinary skills (or luck) to reduce its balance sheet without sending the U.S. economy back into recession, but that policy still produces enough of a slowdown in economic growth to turn the U.S. budget deficit and the Fed's balance sheet back into a front-burner issue.

Remember this lesson from the last two financial bubbles -- the strategies and "insurance" that traders and investors rely upon to reduce losses in a crisis can actually increase the severity of the crisis. If you plan ahead -- beginning now – you're less likely to get caught in the stampede for the exit.

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At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column in his personal portfolio. The mutual fund he manages, Jubak Global Equity Fund(JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did not own shares of any stock mentioned in this post as of the end of September. Find a full list of the stocks in the fund as of the end of September here.

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Jim Jubak's column has run on MSN Money since 1997. He is the author of the book "The Jubak Picks," based on his market-beating Jubak's Picks portfolio; the writer of the Jubak's Picks blog; and the senior markets editor at MoneyShow.com. Get a free 60-day trial subscription to JAM, his premium investment letter, by using this code: MSN60 when you register at the Jubak Asset Management website.

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