How To Play Federal Reserve’s Moves With ETFs

The Federal Reserve has flooded the economy with money. As the excess liquidity is being moved around, the markets and exchange traded funds (ETFs) are showing new opportunities for investors who want to capitalize on what Bernanke & Co. are doing.

Short-term incentives and measures to stoke the economy are not fixing the real problem of sustained growth as businesses reduce payrolls, bank lending contracts, and consumers save more and spend less, comments Steven Pearlstein for The Washington Post.

The Federal Reserve took bold and necessary steps to prevent the collapse of the financial system. But the Fed also created so much liquidity that some fear that another financial bubble is forming.

As the money flew off the printers, the Fed was cutting interest rates in inter-bank lending to basically zero. However, banks kept interest rates unchanged for everyone else, and the result is that “spreads” between bank-to-bank lending and lending to everyone else are close to record highs.

The entities that are actually borrowing are hedge funds and other investors who use the money to purchase stocks, corporate bonds and commodities, pushing prices higher. Some ETFs to watch for activity include:

• DIAMONDS Trust, Series 1 (DIA): up 14.0% year-to-date
• PowerShares QQQ (QQQQ): up 43.3% year-to-date
• SPDRs S&P 500 (SPY): up 19.1% year-to-date
• iShares iBoxx $ Invest Grade Corp Bond (LQD): up 8.9% year-to-date
• iShares S&P GSCI Commodity Indexed Trust (GSG): up 4.9% year-to-date

The excess liquidity is also being used to finance new “carry trade,” borrowing at low U.S. rates to buy bonds in places with higher rates.

• POWERSHARES DB G10 (DBV): up 17.7% year-to-date

The Central Bank is determined to stay its course, using anything that will strengthen the balance sheets. Fed officials won’t be increasing interest rates and reducing liquidity until they decide the economic recovery has a proper foothold.

For full disclosure, Tom Lydon’s clients own shares of LQD and QQQQ.

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