Sunday Musings: Higher Interest Rates Ahead?

Ulli Uncategorized Contact

Reader Jim pointed to an article titled “Bracing for Higher Interest Rates.” Here are some highlights:

That was the unmistakable message from the Federal Reserve last week when it increased the discount rate, the rate it charges banks for borrowing reserves. Although the move came sooner than many expected, it was a healthy step toward more normal conditions and a sign the banking system is healing. The Fed stressed that the move doesn’t mean any imminent rise in the more important federal-funds rate. Despite the soothing words, it’s a clear warning that near-zero interest rates won’t last forever, and that the Fed is prepared to act when necessary to raise rates.

In the abstract, this can’t be a surprise. With short-term rates near zero, and even longer-term rates the lowest they’ve been in my lifetime, interest rates really couldn’t go much lower. But the question has always been one of timing. It’s not clear exactly what the Fed means when it says it won’t raise the federal-funds rate for an “extended time.” Is that three months? Six? The Fed itself may not know for sure. But we now know it won’t be an indefinite period. The tightening cycle has begun.

This has significant implications for investors, since markets anticipate events. Assuming we are in the very early stages of a credit-tightening cycle, investors need a whole new strategy for a world of rising interest rates.

Reader Jim came to the following conclusion:

1. The dollar should increase in value
2. Gold should lose value
3. Junk bonds should lose value

So the trend is up for UUP, down for GLD and JNK. What you think?

While I agree that eventually higher interest rates will be in the cards, the timing part is the big unknown. Currently, we are stuck in a severe deflationary scenario along with a weak economy, both of which do not support higher interest rates.

Of course, the potential always exists that we end up in a “stagflation” environment, where economic growth stagnates and inflation rises along with interest rates. Articles like the above one make a good case, but that does not mean you need to adjust your investment strategy.

The key is to go with the trends as they are right now and make corrections if and when they change and not before. Why? Because you’re basing your decision on guesswork of what might be happening and not on facts as they are right now.

In Jim’s example, the major trend for UUP, JNK and GLD is up, and if you have positions wait until the trend turns before liquidating or, better yet, let your trailing sell stop be your guide as to when to get out. Wild guesses as to what may or may not be happening will inevitably lead to investment losses.

Disclosure: We currently have holdings in the funds discussed above.

Bond ETF Bubble Protection

Ulli Uncategorized Contact



ETF Trends featured “How to Protect Yourself from a Bond ETF Bubble.” Here are some excerpts:

It’s going to happen sooner or later: interest rates can’t remain at record lows indefinitely. The Federal Reserve at some point is going to have to step in and raise them. If you’re holding bond exchange traded funds (ETFs), you need to understand the risks and how to cope.

Bond sales are booming. Nearly $400 billion has gone into bond funds since the start of last year. Those sales have pushed prices higher; corporate bonds and Treasuries have gotten increasingly pricey.

Where do you come in? The primary risk lies in inflation, Arends explains. As consumer prices increase, the interest you’re getting from your bonds becomes worth increasingly less. When bond yields are high, this isn’t much of an issue, but right now bond yields are low. Inflation could sock investors once it kicks in. But that’s not all: when inflation kicks in, the government tends to raise short-term rates.

Some people argue that bonds and related ETFs are a reasonable value, and inflation will stay subdued.

No one is certain about what’s going to happen or when it will happen. The best you can do is to be on your guard and ready to act.

Don’t buy mid- and long-term bonds at their current levels. Long-term bonds will be hit hardest when yields rise.

Consider corporate bond funds, which are offering attractive yields right now: SPDR Barclays Capital High Yield (JNK), iShares iBoxx $ High Yield Corporate Bonds (HYG) and iShares iBoxx $ Investment Grade Corporate Bond (LQD).

Check out TIPs bond funds. Treasury Inflation-Protected Securities are bonds with built-in inflation protection. Right now, the 20-year TIPS bond promises to pay about 2% a year on top of inflation. iShares Barclays TIPS Bond (TIP) or iShares Barclays 1-3 Year Treasury Bond (SHY)

Vanguard Utilities ETF (VPU) yields about 4%.

I have compared the various ETFs mentioned in the article in the above chart. The red arrow shows that all bond ETFs took a dive during the 2008 massacre, some more so than others.

What it comes down is that it really does not matter which ones you own from the above list, you still need to watch the long-term trend. Yes, that means that there are times when bond funds can be held and there are times when they need to be sold, which translates into the use of a sell stop.

As discussed in a previous post, depending on the volatility of the bond ETF, you can apply the same sell stop as with equities (7%), while for slower moving funds, you could reduce that to 5%.

Look at your risk tolerance and establish an exit plan “now” and not when the market heat is on and interest rates are heading higher.

While I don’t see this happen in the immediate future, you should, nevertheless, be prepared to act.

Disclosure: We have holdings in some of the ETFs discussed above.

No Load Fund/ETF Tracker updated through 2/25/2010

Ulli Uncategorized Contact

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

Another roller coaster ride with the major indexes ending up slightly to the downside.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has now crossed its trend line (red) to the upside by +3.85% keeping the current buy signal intact. The effective date was June 3, 2009.



The international index has now broken above its long-term trend line by +2.73%. A Buy signal was triggered effective May 11, 2009. We are holding our positions subject to a trailing stop loss.

[Click on charts to enlarge]
For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

Why China Buys Our Debt

Ulli Uncategorized Contact

Reader Tom sent in the following video designed to enhance your understanding of China. It’s very interesting analogy, especially the punch line. Look for it at the end.

[youtube=http://www.youtube.com/watch?v=UXPtdQYOgw8]

Waning Confidence

Ulli Uncategorized Contact


Not surprising, although unexpected to many, the consumer confidence reading fell to a 10-months low yesterday taking the starch out of the market with all major indexes giving back some of last week’s gains.

This brings the validity of the current recovery back on the front burner. With unemployment and underemployment at records levels with no end in sight, real estate prices still mired in a downward trend and debt levels at unsustainable levels wherever you look, how is the consumer supposed to feel?

At the same time, we continue to battle some of the technical resistance points that have put up a formidable fight. Namely the 1,100 level on the S&P; has proved to be a barrier for several months now that can’t be cracked for any length of time.

A new driver is indeed needed to push the markets out of their sideways pattern. I just happen to look at some positions we established the middle of last September, from which point the S&P; 500 has gained less than 2.5%.

Despite this lack of upward momentum, the major trend has not been interrupted, and yesterday’s drop merely pushed the TTIs (Trend Tracking Indexes) a little closer to their trend lines. The TTIs are positioned +3.42% (domestic) and +2.67% (international) above their long term trend lines.

We continue to hold on to those positions that were not affected by the recent decline.

Tiebreaker

Ulli Uncategorized Contact

No, this discussion is not about a tiebreaker in a tennis match, although with a similarly intended outcome.

Reader David emailed recently and pointed out that in the StatSheet some of the mutual fund/ETF rankings (as per my M-Index) were showing a tie.

What should he use as a tiebreaker? Should the M-Index rankings be shown not only as a whole number but also with decimal points to make a clear distinction as to the pecking order?

Since this is not exact engineering science, decimal points are not needed. If I find several funds/ETFs with the same M-Index, I look at all other momentum figures of the tied funds as well. I compare 4-wk, 8-wk, 12-wk and YTD. Ideally, I want to see positive numbers in all columns.

With the recent market pullback, that may not be possible, so my main focus will be on the 4-wk number. Say, I have 3 funds that are tied with the momentum index, but one shows me a positive 4-wk figure, that would be my preferred choice.

Why?

It tells be that this fund has either survived the recent sell-off intact or has recovered quickly, which would make it preferable over those that are still showing red ink.

The purpose here is to make a selection with as little emotional involvement as possible and to have a clear process for making a selection. As with all investments, this does not guarantee a successful outcome, but it may make it easier for you to break a tie when you encounter one such as David did.