Wall Street has an old saying: “Don’t fight the Fed.”
That means if your investment strategy isn’t in synch with the central bank’s policies, you’re going to lose money.
I have an update: “Don’t follow the Fed.” That’s because the Federal Reserve, under Chairman Ben Bernanke, is about to torpedo the $39 trillion bond market.
Twice in a little more than a decade, the Fed slashed rates, flooded the markets with cheap money and encouraged ridiculously risky behavior.
And twice before, those moves inflated asset bubbles — first in dot-coms and second in housing.
And when those bubbles got too big for even the Fed to ignore, policy makers were forced to reverse their position. That swiftly led to historic declines in investors’ wealth and buried the economy in a recession.
|The Fed is about to torpedo the $39 trillion bond market.|
Third Time Unlucky
Now it’s happening again — this time in the ultimate bubble that is the bond market. Consider this: In the four years through 2012, bond mutual funds took in a net $1.05 trillion, the most in the history of the country’s capital markets.
Not only that, it compares with a net $881 billion into stock funds from 1997 to 2000, right before the dot-com boom went bust. So just considering the amount of money that’s at risk, the bond bubble could be even more destructive. And that doesn’t even include the follow-on effect that higher interest rates have on loans and mortgages.
If you haven’t taken steps to protect yourself, it’s not too late. The yield on the benchmark 10-year Treasury has surged, but it’s still only around 2.5 percent. The real pain lies ahead.
Besides shielding yourself, now is the time to go for profits.
Though yields have stabilized in the past couple of days, we’re clearly embroiled in one of the worst bond bear markets in years. Municipal bonds are just one illuminating example of how much suffering we’re talking about.
Check this out: Bloomberg has been tracking “sell” interest in the muni-bond market since 1996. It maintains a daily count of how many muni bonds that institutional investors want to sell on any given day. Guess what? Last Monday, that “sell” list totaled roughly $2 billion, the highest count in history.
Why are big bondholders trying to get out? Because they’re losing money quickly and their investors are stampeding for the exits. Muni bonds have plunged by more than 5 percent this month. That’s the worst crash since September 2008, when global credit markets froze.
We’ve already seen $5.3 billion yanked from muni-bond mutual funds in the past three weeks, according to Lipper. If that redemption wave doesn’t ease up, look for even more bonds to be dumped on the market. That, in turn, will exacerbate the downward spiral.
The Fed’s Waning Influence
Now, Wall Street economists are laying the blame for this latest move at the feet of the Fed’s Bernanke. They’re saying he lit the fuse for this implosion in his most recent press conference last week by suggesting that, later this year or next year, the Fed will have to ease back on its money-printing scheme.
If that were the case, all he or his fellow Fed members and bank presidents would have to do is take back that pledge. And, sure enough, other Fed members have been trotting in front of the microphones this week to say, essentially: “Stay calm. We’re not tightening policy any time soon. Rates will stay low for a long time, even if we eventually reduce the quantitative-easing program a bit.”
But I have an entirely different view of the situation. My thesis is simple: The Fed has lost control of the bond market. The bubble has gotten so big because it was allowed to inflate for so long, a fiasco is a done deal no matter what the Fed says or does.
That’s what happened with dot-coms starting in early 2000, when drastic Fed easing failed to prevent the Nasdaq from losing more than 70 percent of its value.
And that’s what happened with housing beginning in 2006, when even more drastic Fed easing (not to mention every extraordinary lending program or bank bailout they could conjure up) couldn’t prevent the worst real estate crash since the Great Depression.
And I believe that’s what is now happening in the bond market. We’re going to get a massive unwinding of rising prices whether policymakers want it or not.
Time to Take Control
So I recommend you take matters into your own hands. That means:
- Selling any remaining long-term bond exposure during the next short-term market rally. We could see one at any time because the velocity of the bond-market move has been incredible, and a slight bounce is likely.
- Paring your stock exposure by grabbing profits. Many stocks have had their values artificially inflated by cheap Fed money. With the bond market cracking, those stocks are likely to teeter.
- Looking to get more aggressive and turn this bond-market rout into a profit opportunity. Consider alternative-investment strategies designed to do exactly that. As a starting point, I recommend you read up on inverse bond ETFs. Those investment vehicles rise in value when bond prices fall, making them a great hedge against rising rates.
I’ll have more on this in the coming days and weeks, so stay tuned.
To turn another saying about the Fed on its head: The Fed is not your friend. The central bank has helped engineer two massive bubble-and-bust cycles. Now the third is on its way.
Until next time,