Issue 29 • JUNE 17, 2009

The Next Financial Storm Brewing in Bonds ...

What the Winnebago Bailout Means for Interest Rates

It seems not a day goes by without Washington jumping in with both feet to change the free market rules …

No one knows what Washington will do next ... or what the long-run consequences of all these bailouts will be.

It started when we were told America’s biggest banks were in desperate need of a bailout. Giant financial institutions like Citigroup, AIG, and Bank of America were simply “too big to be allowed to fail,” or so they said.

For the sake of argument, I can buy that line of reasoning ... but manufacturers of recreational vehicles? Are they also too big to fail?

If not, then how do we explain bailouts for Gulfstream and Monaco Coach, among other R.V. makers?

The Fed is vastly expanding its bailout umbrella — widening the scope of “eligible collateral” accepted by the Term Asset-Backed Securities Loan Facility program (or TALF) to include not just R.V.s ... but also boats ... motorcycles ... even snowmobiles!¹

Where will it end?

The scary part is that I’m not making this stuff up! You can see for yourself under the FAQ section of the New York Federal Reserve Web site by going here: Eligible Receivables.

The truth is, with credit markets still crunched and many banks hoarding cash rather than lending, the Fed has become the lender of last resort to a growing list of industries outside the financial sector.

But the stakes are high. Besides the obvious risk to taxpayers who are footing the bill, the Fed is gambling with its own credibility as a supposedly “independent” central bank.

The Fed is supposed to be above the political fray, but according to the New York Times, “executives and lobbyists now flock to the Fed, providing elaborate presentations on why their niche industry should be eligible for Fed financing or easier lending terms.”²

So far, the Fed has shelled out $27 billion in TALF-related funds, but eventually the program could provide as much as $1 trillion in total financing ... to promote fishing boat and snowmobile sales ... among other critical funding requirements.³

It sounds like a joke ... but it is certainly no laughing matter. These crazy bailouts by the Fed are laying the groundwork for the next financial storm on the horizon.

This $1 trillion in TALF funding is just a small drop in a big bucket of nearly $13 TRILLION in spending, lending and other guarantees that Washington has committed taxpayers to so far.⁴

It’s as if the U.S. Treasury is writing a blank check to spend all the money we have ... and all the money we don’t have. In fact, this is money that many future generations of taxpayers will be on the hook for … for a very long time.

Fixed Income Investing: 101

Some say, if the banks and automakers are worth saving then, why not bailout other corporations?

Here’s the problem: The unintended consequences of all this spending mean rising long-term interest rates. Rising rates could choke off any recovery before it even gets started. And, we’re already seeing evidence of this.

Let’s start with the math: the U.S. Treasury may have to raise $3.25 trillion this fiscal year alone — which ends in September — to cover soaring deficits, all this bailout spending, and to refund maturing Treasury bonds, according to a Goldman Sachs report.⁵

This unprecedented spending-spree is making fixed-income investors understandably nervous as they ask, “How will Washington pay for it all?”

The answer: a huge supply of NEW bonds must be issued to finance this massive spending spree.

This is where the simple law of supply and demand takes hold. If investors expect a large supply of new bonds to hit fixed-income markets, they’ll demand a higher yield (or interest rate) in order to soak up this supply.

As yields move higher, the price — or market value — of existing bonds moves lower to adjust. This is why bond prices move in the opposite direction of yields, or interest rates.

Bear Market in Bonds: Will this be the Next Financial Storm?

We think it’s a strong possibility and the storm is brewing already. Worries about government spending and soaring deficits have driven up interest rates on long-term government bonds — from 2.1% in January to 3.8% in early June.⁶ At the same time, bond prices plunged. In fact, 30-year U.S. Treasury bond prices fell 10% in just two months!⁷

This is an ominous sign that could mean a major bear market in long-term Treasury bonds could be the next financial storm on the horizon.

The irony is that higher interest rates threaten to undo everything Washington is so desperately trying to accomplish with its bailouts!

That’s because higher rates increase the cost of borrowing for consumers, businesses, and for the U.S. Treasury, too. Any hoped-for recovery could be quickly snuffed out amid higher borrowing costs.

As a result, we could again witness STAGFLATION ... slow or stagnant economic growth AND soaring interest rates, made even worse by high unemployment ... creating a triple-threat for consumers and businesses.

Over the longer term, this could trigger a major secular bear market in long-term government bonds.

A Fixed-Income Strategy to Weather the Storm

The Federal deficit this year is already projected to be a record $1.84 trillion — or about FOUR times more than last year's.

Of course, this doesn’t sit too well with the U.S. Treasury’s best customers — foreign investors, including China, Japan, Europe and others — who are among the biggest investors in U.S. Treasury securities.⁸

The fear, and it’s a real one, is that the value of bonds will tumble, as foreign investors lose confidence in growing U.S. deficit spending, and they begin to sell, or at least shift from long-term to short-term maturities.

This action could have a huge and long lasting impact on the bond market.

The bottom line is that the cost of borrowing money can only go substantially higher for virtually all American consumers and businesses.

This is the third financial storm we’ve been warning about in our emails and in our recent video — the Weiss Wealth Event Webinar. This storm is lurking just over the horizon: a bursting of the last bubble ... the bubble of the U.S. Treasury bond market.

So, how do you invest with this new financial storm on the horizon?

In a word: cautiously.

At Weiss Capital Management, we believe investors are likely in store for a period of rising interest rates, and perhaps inflation, in the years to come. It may be the mirror image of what we experienced over the last two decades, as interest rates and inflation declined.

We don’t foresee this happening overnight ... but gradually over time.

For fixed-income investors, this scenario requires an important mindset change.

Over the last 20 years, it has been ok to buy and hold longer-term bonds. That was because we were in a bond bull market with lower interest rates driving bond prices generally higher, creating capital appreciation opportunities for investors. But you can’t count on bond prices continuing to rise much longer.

The strategy of simply buying and holding bonds may not work for fixed-income investors over the next 20 years. Instead, investors are going to need a flexible, tactical strategy to determine when to invest shorter-term and more importantly when it’s less risky to invest longer term to lock-in the higher yields as they come. Along the way, there are bound to be a number of short-term “trading” opportunities in Treasury bonds which could represent significant profit opportunities for nimble investors

For example, bond prices fell as yields on the benchmark 10-year Treasury backed up from 2.1% in January, to 3.8% in early June.⁹ That’s a BIG correction in a rather short time period. Perhaps bonds, like stocks in early March, have overshot and are now due for a rally?

Although we are wary of owning long-term Treasury bonds for the long haul, we could get an opportunity soon to buy bonds — not for their income potential — but for their short-term appreciation potential during what promises to be a volatile transition period in fixed-income markets.

Look for more from us on bond market investing…

Good investing,

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

P.S. In our Weiss Wealth Event video, we discussed the possibility of a secular bear market in both stocks AND bonds at the same time ... and how to adjust your investments in this environment. For more details, go here to view the event, OR visit: www.weisscm.com/allweather to get your complimentary copy of our All Weather Investor Guide!

¹ New York Times: Lender’s Role for Fed Makes Some Uneasy, 6/13/08
² Ibid.
³ Ibid.
⁴ Bloomberg: Government Bond Yields Rise to Six-Month Highs; Metals Fall, 5/28/09
⁵ Bloomberg: Treasuries Fall on Concern Record Sales Will Overwhelm Demand, 5/27/09
⁶ Bloomberg: Bernanke Conundrum Threatens Housing on Mortgage Rate, 6/8/09
⁷ Bloomberg market data: 6/1/09
⁸ Federal Reserve Board, FMRCo (MARE) as of 12/31/2008
⁹ Bloomberg: Bernanke Conundrum Threatens Housing on Mortgage Rate, 6/8/09