Fed Rate Hike Tomorrow!

When the Federal Reserve meets tomorrow, it will raise its Fed Funds rate for the TENTH time in a row.

Another hike is a virtual certainty on September 20. Then, still more are likely November 1, December 13 and early next year.

Result: The Fed funds rate will be 3.5% tomorrow … 4.25% by year-end … and 5% by March of next year.

And that assumes the Fed does not accelerate the pace of its increases, raising rates by only one quarter of a point each time. If the Fed switches to half-point increments within the next few months, you could soon see the Fed Funds rate at 6% or 6.5% — double today’s level.

Why the Fed Can’t Ignore
Oil and Gas One Day Longer

Until recently, Wall Street was hoping that the Fed’s rate increases would end soon. But with energy prices now barreling higher, that hope is gone.

Late Friday, crude oil busted through the $62 level, making a new high at $62.31 … building a base … and prepping for a brand new blast-off beyond its July highs, perhaps to the $70 – $75 area. Almost anything — another storm in the Caribbean or just the ongoing, chronic imbalance between supply and demand — could make it happen in a heartbeat.

Meanwhile, the price of unleaded gasoline futures has already blasted off, leaving its July highs far behind. This gives you a sneak preview of what’s coming for crude oil, as all energy prices leapfrog each other in an unstoppable march to much higher levels.

Investors in energy are rejoicing. But when the members of the Federal Reserve’s Open Market Committee meet tomorrow, they will do anything but. They will finally have to face up to the reality of surging energy costs and recognize the inevitability of its inflationary consequences.

Plus, they are bound to recall the last time energy prices went through the roof, what it did to the bond market, and how many years of agony it caused.

To see what I mean, turn back the clock 25 years to …

The Bond Crash of ’79

Instead of Tuesday, August 8 … the date was Tuesday, October 8.

Instead of 2005 … it was 1979.

And instead of Alan Greenspan at the helm of the Fed … the Chairman was Paul Volcker.

But while these differences are anecdotal, the similarities with today are fundamental:

Like today, serious troubles were brewing in the Persian Gulf, with a new Shiite-lead government rising to power (in Iran).

And like today, world oil prices were surging, a major source of inflation.

Federal Reserve officials, however, had been very complacent about the inflation, doing virtually nothing to stop it. To nip it in the bud, they should have raised rates sharply and promptly. Instead, they dilly-dallied, holding down their Fed funds rate at low levels or allowing it to rise only gradually.

These abnormally low rates triggered massive speculation in an area generally not associated with risk — U.S. government bonds.

Most people didn’t realize how quickly government bond prices could fall. They’d heard of booms and busts in the stock market, but they knew nothing about booms and busts in the bond market.

They also didn’t quite grasp why falling bond prices automatically came with higher bond yields. But it was actually quite simple:

An investor bought, say, a $10,000 bond paying a fixed rate of 5% or $500 in interest each year. If the bond’s price fell in half, you could pick it up for just $5,000. Your yearly interest, calculated on the $10,000 face value, was still $500. But since you invested only $5,000, your $500 in interest gave you a yield of TEN percent instead of just five. In short, as the bond price fell in half, its yield doubled.

Sound extreme? Perhaps. But this is the kind of situation that was about to happen starting in 1979.

Meanwhile, the abnormally low interest rates of the ’70s also fueled rampant speculation in an area far from Wall Street — the housing market.

So there we are, in October 1979, with unbridled speculation in the two same sectors of the economy as today — bonds and housing.

But it was mostly hidden. Americans saw virtually nothing about it in news headlines. Economists didn’t factor it into their models. And most investors didn’t have a clue regarding what was really happening to their money — let alone what was about to happen.

Tracking the Bubbles

To us, the speculative bubbles of the 1970s were obvious.

My father, his older brother and l saw the signs of trouble a few years earlier. Working out of our apartment on East 16th Street in Manhattan, Dad extracted the data from the Fed’s quarterly Flow of Funds report, while my uncle or I compiled them on a spreadsheet. We saw how the nation’s biggest financial institutions — S&Ls, banks, insurance companies and brokers — were all loading up with bonds and risky loans.

They were taking these risks because the Fed was practically guaranteeing the profits: They could borrow huge amounts of short-term money at low rates. They could use that money to buy long-term bonds with higher yields. And then they could just sit back and collect the difference.

In the late 1970s, our research also turned up signs of trouble with another tool — the charts Dad kept on the wall of his office. The charts showed that short-term rates were rising faster than long-term rates.

This was an ominous sign for all those banks, S&Ls and other investors who were speculating in bonds with short-term financing. It meant the rate they were paying for their borrowings was going up quickly. But the yield they were getting on their bonds was going up slowly.

They were getting squeezed. They were itching to pull the trigger and dump their bonds.

Dad and I plotted the charts daily, and the silent, hidden drama unfolded before our eyes. So we issued our forecast: Bond investors are going to dump their bonds. Bond prices are going to crash, and bond yields are going to surge.

Shock Treatment

Soon thereafter, surging energy costs finally began to spread through the economy, and fears of rampant inflation began to sweep through Wall Street. Many bond investors stopped buying while many others started selling.

In Washington, this was cause for growing concern. If bond investors went on a buyer’s strike, where would the U.S. Treasury raise the money it needed to run the government? To finance the military? To meet its payroll?

Unless bond investors continued buying U.S. government bonds, how would federal employees — including members of Congress, the President, his staff, and even Fed officials themselves — cash their paychecks?

Behind the scenes on Wall Street, events were coming to a head. And behind closed doors in Washington, the Fed’s Open Market Committee was meeting.

They figured to keep bond investors happy, they’d have to do two things in a big hurry: Raise short-term rates to fight future inflation. AND let long-term yields go up to give bond investors a better return right away.

The meeting ended, and the Federal Reserve stunned the world by raising its target rate for Fed funds — not by a quarter point, not by a half point … but by ONE AND A HALF percentage points. The equivalent of SIX, quarter-point rate hikes! All in one day.

Then, as if that wasn’t enough, just a few weeks later, they did it again — this time hiking rates by TWO and a half percentage points.

That was a total increase of FOUR percentage points in just one month, the equivalent of SIXTEEN quarter-point hikes.

Wall Street was shell-shocked. Bond investors, already on the brink of selling, dumped their bonds in wild abandon. Bond prices plunged. Bond yields soared. And they continued to do so in wilder and wilder swings for two more years.

Treasury bonds fell to 55 cents on the dollar. Most corporate bonds and municipal bonds fell even more sharply. The 3-month Treasury bill rate surged to 16%; the Fed funds rate, to 20%. Bond investors lost a fortune. Bank stocks collapsed. Housing stocks followed.

The Next Bond Crash

Most people today assume that the next bond market decline couldn’t possibly be as bad as the record-breaking decline of 1979-80. But today, we see circumstances that are very similar.

Much like in the late 1970s, we see trouble in the Persian Gulf … the rise of a new Shiite government (in Iraq) … surging oil prices … rising inflation … a complacent Federal Reserve … rampant speculation in bonds … rampant speculation in housing … short-term rates rising faster than long-term rates … and bond speculators getting squeezed.

Indeed, it never ceases to amaze how closely history is repeating itself.

Granted, inflation doesn’t seem to be as bad as it was 25 years ago. But that’s offset by a new situation which is far worse than it was back then: Foreign ownership of U.S. bonds.

In the past, most U.S. government bonds were bought by American investors. And the primary concern of American bond investors was a decline in the dollar’s purchasing power at home. That usually took months — even years — to unfold.

Now, more than half of U.S. government bonds are bought by foreign investors and governments. And the primary concern of foreign bond investors is a dollar plunge in foreign currency markets. That can happen in weeks or even days.

Bottom line: Most of today’s bond investors could be prone to dumping their bonds sooner and faster.

Meanwhile, in the housing market, the money to finance the boom has also been coming mostly from investors in bonds — not just from S&Ls and banks like in the old days. And these investors now hold trillions of housing-related bonds. If they start dumping, the money to finance homes could disappear and their rates could go through the roof.

As I explained on Friday, no one knows what the future will bring. But one thing is relatively certain: There will be many more rate hikes after tomorrow’s!

Here’s What I Recommend …

First, stay focused on energy. If you’re already on board, stick with it. If not, take advantage of any correction to jump in. Larry’s recommendations are going gangbusters, up as much as 161% in just 13 days. And today, he’s issuing a brand new recommendation which could do as well, or better. (See his report.)

Second, avoid long-term bonds. The decline you can suffer in your principal can easily wipe out any advantage you may get from their yield.

Last week, for example, I showed you how the price of Treasury bonds fell from about 119 in late June to 115 on Thursday. And on Friday, it plunged even further, to 114 and a fraction.

For each $10,000 you invest, that’s a principal loss of over $400 in just six weeks. In contrast, if you’ve been keeping your money short term — such as in Treasury bills or an equivalent money market fund — your entire $10,000 would be intact.

What about the fact that long-term Treasury bonds give you a better yield than short-term Treasury bills? Well, right now, that yield advantage is a meager one percentage point and a fraction per year. So in the six weeks, for each $10,000 invested, all you could have gotten in extra yield was about $10.

Which would you prefer? A meager $10 in extra yield with the Treasury bonds? Or $400 more in principal with the Treasury bills?

One way is to buy the 3-month Treasury bill directly from the U.S. Treasury Department through their Treasury Direct program.

The advantage: You bypass all intermediaries and pay no fees. The disadvantage: To get your money back, you need to wait the full three months until maturity … or you need to transfer your Treasury bills to a broker to sell them on the secondary market. But for that transfer, you need to wait a couple of weeks.

Another way is to use a money market fund dedicated to short-term Treasury securities and equivalent, such as the American Century Capital Preservation Fund or the Weiss Treasury Only Money Market Fund.

The primary advantage: You can access your funds within 24 hours through a wire transfer or by simply writing a check.

Second, be sure to stay on track with my portfolio recommendations in the Safe Money Report. The August issue just came out. If you’re a subscriber, you should have gotten my e-mail notification of the web posting on Friday, and the printed version should be in your mailbox early this week. We just saw huge gains even in our most conservative energy recommendations. If you missed those, be sure to get my current recommendations.

Third, for money you can afford to risk, consider put options on interest-sensitive investments. The more these investments fall, the more the put options soar. And right now, that’s exactly what’s happening.

Look at New Century Financial Corp., for example, a major lender of “subprime” (high risk) loans.

Its stock is getting killed by rising rates. Last week, it plunged almost two points on Wednesday, three on Thursday and another three on Friday — a loss of over 14% in just three days.

Meanwhile, in the same 3-day period, a put option we recommended on the stock surged by 108%.

Another prime example: Lennar Corporation, one of the largest home-building companies in the U.S.

On Friday alone, it plunged 4.5%, driving up the value of a put option we recommended by 50% — in just one day.

Naturally, options are volatile and can also fall. But if you invest strictly funds you can afford to lose, the purchase of options can never negatively impact your keep-safe funds. That’s because, even in the worst case scenario, the most you can lose is the amount you invest, plus any commission you pay your broker. The potential profits, meanwhile, are virtually unlimited.

(For more information regarding options on interest-sensitive investments, see my latest report.)

No matter which route you take — capital conservation, hedging, or options — the time to get ready is right now. The Fed is jacking up its rates again tomorrow. In September they’re going to do it again. And they’re gong to keep on doing it month after month.

Don’t get caught flat-footed.

Good luck and God bless!

Martin

About MONEY AND MARKETS

MONEY AND MARKETS is written by the editors and financial analysts at Weiss Research. To avoid any conflict of interest, our editors and research staff do not hold positions in companies recommended in MAM. Nor does MAM and its staff accept any compensation whatsoever for such recommendations. Unless otherwise stated, the graphs, forecasts, and indices published in MAM are originally developed and researched by the staff of MAM based upon data whose accuracy is deemed reliable but not guaranteed. Any and all performance returns cited must be considered hypothetical. Contributors: Marie Albin, John Burke, Michael Burnick, Beth Cain, Amber Dakar, Larry Edelson, Scot Galvin, Michael Larson, Monica Lewman-Garcia, Anthony Sagami, Julie Trudeau, Martin Weiss.

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