Shock and Disappointment

It’s so quiet on Wall Street that traders are literally falling asleep at their desks.

The Dow Jones is behaving like a discarded ping-pong ball – bouncing up and down a few times and then dribbling to a virtual standstill. The VIX index, a key measure of market volatility, is the lowest in over eight years. Everywhere, investors are bored, complacent, or both.

But it’s the calm before the storm.

Just nine days from now, on Wednesday, June 30, nine men and three women will end a meeting in Washington, D.C. and make an announcement that will change the course of history.

The group’s name: The Federal Open Market Committee of the U.S. Federal Reserve Board.

Their announcement: To raise U.S. interest rates and officially end one of the longest periods of record-low interest rates in modern history.

What will be the outcome of this momentous decision? How will it impact your investments? How can you prepare? As I see it, there are only two possible scenarios:

Scenario A: DISAPPOINTMENT

Let’s assume the Federal Reserve announces a QUARTER-point increase in its official target for the short-term interest rate it controls – the overnight Federal funds rate. Instead of 1%, it decides to aim for 1.25%. Result:

All over the world, millions of bond investors will be sorely disappointed. Many will start dumping their holdings as quickly and as efficiently as possible. Sooner or later, bond prices will fall, and market interest rates will soar.

Why?

Put yourself in their shoes and you will understand the reason.

Let’s say you’ve invested $100,000 of your hard-earned money in U.S. Treasury bonds. And let’s say you’re due to get your principal back 20 years from today, in 2024.

Right now, based on the first five months of this year, you see that consumer prices in this country are already rising at an annual clip of 5.1%.

So you ask yourself: If inflation is already that high, how bad is it going to be next year? What about the years after that? And how much is my $100,000 bond going to be worth in today’s dollars by 2024?

$50,000? $40,000? Less?

Meanwhile, you also see that the Fed is doing virtually NOTHING to stop the inflation.

Heck, the last time inflation was seriously raging in this country, back in 1980, the Fed raised the Federal funds rate to 18% (EIGHTEEN TIMES its current level). And now, all they’re doing is raising it from 1% to 1.25%?! Who do they think they’re kidding?

Higher interest rates are supposed to be their number one weapon for fighting inflation. So how can they expect 1.25% interest to be enough to catch up with 5.1% inflation?

Even if the Fed’s 12-member committee raises rates by a quarter percent after EVERY meeting they’ve got scheduled for the remainder of this year – August, September, November, and December – it will STILL be at only 2.25% by year’s end.

Is THAT enough to tame 5.1% inflation? I fear not.

It’s a joke, but you’re not laughing. Nor are you going to wait around to see what happens next. You call your broker and issue one four-letter command: “SELL! Sell my $100,000 in bonds. NOW. At the market.”

Scenario B: SHOCK

Let’s assume the Fed jacks up interest rates by a HALF percent – to 1.5%. Now, instead of disappointment, the market responds with shock.

Put yourself in the shoes of the typical institutional bond investor – such as a bank, brokerage firm, or insurance company – and you’ll see why.

For many months now, you’ve been making a killing from interest rates. You’ve been borrowing short-term money at record-low rates and investing that money in notes and bonds that pay much higher rates, pocketing the difference.

Now, suddenly, the Fed jacks interest rates up by a HALF percentage point, and you’re hit hard from both sides: You have to pay MORE to finance your bond investments. Plus, at the same time, the value of your bonds is LESS, as bond prices sink.

What do you do? You get the heck out, of course. You dump your bonds, at the market, now!

WHICH WILL IT BE?

Will the Fed disappoint bond investors with only a quarter-point hike in interest rates … or will it shock them with a half-point hike?

Most observers expect a quarter point. Others are beginning to speculate on the half point. But naturally, no one knows for sure.

Here’s what we DO know:

FIRST, we know that in the wake of the first rate hike this month, there are almost definitely going to be MORE rate hikes this year. So whatever happens on June 30, it will just be the opening salvo.

SECOND, we know that the inflation being reported by the government understates the actual inflation in this country. For example, the true increase in housing costs alone is MANY times more than what’s factored into the government’s consumer price index.

THIRD, we know that, all over the world, millions of individual investors and tens of thousands of institutions are holding more inflation-sensitive investments than ever before in history. At year-end 2003, they held …

$4 trillion in U.S. Treasury securities, eroded by rising inflation …
$6.1 trillion in securities issued by U.S. government agencies or backed by U.S. government-sponsored enterprises, eroded by rising inflation …
$1.9 trillion issued by municipal and state governments, eroded by rising inflation …
$6.5 trillion issued by U.S. and foreign corporations, eroded by rising inflation …
$9.4 trillion in mortgages, eroded by rising inflation …
plus $6 trillion in other debts, also eroded by rising inflation.

That’s $34 trillion in interest-bearing debts – over TRIPLE the size of the entire U.S. economy … over DOUBLE the total value of all the stocks listed on all exchanges in the United States … and more than SEVEN TIMES the amount invested in mutual funds – all tied to interest rates, and nearly all directly vulnerable to rising inflation.

Think about that for a moment. You invest in mutual funds, right? So do millions of others, correct? Well, for each and every dollar you and they invest in mutual funds, there are over SEVEN dollars invested in these interest-bearing debts.

Think I’m exaggerating? Check it out for yourself. Just go to …

http://www.federalreserve.gov/releases/z1/current/annuals/a1995-2003.pdf

Then scroll down to page 52, Table L.4, the Fed’s latest data on debts and mutual fund ownership in America.

At the top right of the chart, you’ll see the total figure for interest-bearing debts: $34,029.1 billion ($34 trillion).

Then, at the bottom right of the chart, you’ll see the sum for all mutual fund shares: $4,653.2 billion ($4.6 trillion).

Divide the $34 trillion by the $4.6 trillion and you get $7.31 – the amount investors own in notes, bonds, and other interest-bearing instruments for every dollar they hold in mutual funds.

Now, you know what happens when investors sell their mutual funds all of a sudden. It hits the stock market like a sledgehammer.

So, guess what happens when investors sell their bonds and other debt instruments! Whether they’re driven by disappointment OR by shock, the result is the same: It slams the bond market like an avalanche.

Bond prices collapse. Market interest rates soar.

WHAT I DO WITH MOST OF MY MONEY

People often ask me: How do you accumulate a nest-egg of money over time? My best answer: Don’t spend it.

And ever since I can remember, I’ve been practicing what I preach.

When I was nine, my family moved back from central Brazil to the United States, and we lived in Long Beach, New York. At first, I suffered culture shock. I especially missed my private jungle and its inhabitants.

But soon, I adapted to the new environment. I started a paper route, delivering Newsday six days a week. Soon, I had so many subscribers packed into such a small city area, I didn’t need a bike to make my deliveries – just an old shopping cart. Since I was the youngest paper boy the neighborhood had ever seen, tips were generous, and I saved every penny in the safest place I could find.

Today, my philosophy of investing hasn’t changed very much: For the money you must keep safe, don’t do it. Don’t invest. Instead, sock it away.

Then, if you want to peel off some portion to invest, fine. If you’re risk-oriented, invest more. If you’re risk-adverse, invest less.

No, I’m not against stocks. My primary gripe with stock market investing is that most people overdo it. And with the Fed holding interest rates so low for so long, that’s especially true today.

What irks me most is that stocks are sold to you as a SAVINGS vehicle, when in reality, they’re nothing of the kind. Stocks have never been a proper place for savings and never will be. They’re risk investments. Pure and simple. And now, with the Fed ending its low-interest rate policy, I’m afraid that risk could suddenly return to haunt millions of investors.

Bottom line: If you want a place to SAVE your money, look elsewhere.

My favorite vehicle is a money market mutual fund that invests exclusively in short-term Treasury securities or equivalent. And there are many, including American Century’s Capital Preservation Fund and a few dozen other excellent Treasury-only money funds to choose from, operated by major mutual fund families, banks, or brokerage firms. Plus, also consider our own Weiss Treasury Only Money Market Fund.

The yield you’ll get on these money funds right now is dreadfully low, of course. But starting next month, in the wake of the Fed’s first interest rate hike in four years, I’m convinced that’s bound to change as interest rates move higher and higher.

Moreover, nearly all money funds invest strictly short-term. So unlike medium-term notes or long-term bonds, the value of their shares does NOT go down when interest rates go up.

Each share is fixed at $1 and no Treasury-only money fund has ever veered from that price – not in this century and not in the past century. In fact, they have always been priced at $1 ever since Dad started the very first one back in the 1960s.

How do you make money? They pay you interest by adding more $1 shares to your account.

The key is that rising interest rates is GOOD news for anyone holding these funds.

Plus, most of the Treasury-only money funds also offer advantages that bank accounts can’t touch – no withdrawal penalties, truly free checking, low fees, an exemption from local and state income taxes, the highest-quality investments in the world today and LIQUIDITY.

If you do nothing else but get a substantial chunk of your money into one of these Treasury-only funds, I think you’ll be better prepared for the coming interest rate hikes than the overwhelming majority of investors in the world.

Good luck and God bless!

Martin

Martin D. Weiss, Ph.D.
Editor, Safe Money Report
Chairman, Weiss Ratings, Inc.
martinonmonday@weissinc.com

Martin Weiss and “Martin on Monday” are non-partisan. Third-party ads do not necessarily represent their opinion and should not be interpreted as an endorsement.

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