By Brenda P. Wenning
NEW YORK ( AdviceIQ) -- For some time now, I have warned about the crash that is sure to come when the Federal Reserve tightens monetary policy. We got a glimpse of how bad it could be last month.
On May 22, Fed Chairman Ben Bernanke told Congress that the central bank might cut the pace of its bond purchases. Currently, the Fed buys $85 billion in government bonds and mortgage-backed securities.
This program, called quantitative easing, aims to encourage investment by effectively lowering interest rates, but it also drives a stock market bubble. This hint that it might pull back on stimulus was enough to deflate it, at least for a few days.
First, U.S. Treasuries slid as traders anticipated less demand for bonds from the Fed. Stocks also fell. The Standard & Poor's 500 ended May 22 down 0.8%, but the real pain came overseas. The next day, Japan's Nikkei index dropped 7.3%, the sharpest plunge since the tsunami of 2011. In comparison, Europe's leading indexes closed down 2.1%, In the U.S., the S&P 500 was down just 0.3% at the close, but the day was marked by high volatility.Exacerbating the selloff, the flash HSBC (HBC) Purchasing Managers' Index confirmed fears of a manufacturing slowdown in China. The index fell from 50.4 points in April to 49.6 for May. Anything less than 50 points indicates a contraction. This could mean that China's domestic demand is sagging and overseas buyers are pulling back on orders, a very bad sign for the global economy. Keep in mind that the Bernanke didn't announce the end of quantitative easing. He merely echoed other Fed officials, saying that they may scale back the pace of its bond buying steadily at its next few meetings if they see signs of sustained economic growth. That's a big if. The most recently reported unemployment rate was 7.5%, which is still a solid percentage point above the Fed's target. Previously, the central bank promised that it plans to wind down the stimulus when unemployment reaches 6.5%. Given that the Fed buys $85 billion in bonds a month and that quantitative easing has been going on for five years with only middling results, I say a halt to quantitative easing is long overdue. Now we have a socialized bond market. As a result of its bond buying, the Fed today owns a record 30.5% of the U.S. bond market, including 30.32% of all outstanding 10-year equivalents, Zerohedge reports. This reduces the amount of bonds available to the private sector. "America may or may not be becoming increasingly socialist and/or nationalized," Zerohedge concluded, "but there is no doubt about it: Its bond market most certainly is." Still, quantitative easing continues unabated. The program may not create jobs, as intended, but if it were to stop tomorrow, stock prices are likely to plunge as government borrowing costs rise, the Fed's portfolio of bonds decline in value and inflation increases. As an investor, you need to be prepared for this eventuality. For now, QE goes on, the federal government continues spending beyond its means, the dollar is weak, interest rates are low and unemployment remains high. When the Fed pulls back, it could hurt both the stock and bond portions of your portfolio. -- By Brenda P. Wenning, president of Wenning Investments in Newtown, Pa. AdviceIQ is a network of financial advisors that writes insightful articles for the public about investing and wealth management. All articles are edited by AdviceIQ's editor in chief, Larry Light. AdviceIQ certifies that all its advisors have no regulatory infractions. To subscribe to AdviceIQ's Rss feed for personal finance articles written by financial advisors and AdviceIQ editors,