The Case for Higher Rates

The two-by-four that’s needed for this financial markets game of Whac-a-Mole is a sharp (steep) increase in interest rates.

A series of small interest rate increases won’t be enough. The Fed increased interest rates 17 times, by 25 basis points each time, between 2004 and 2006, and it had absolutely no effect on housing-market speculation - which, as we now know, was way out of hand. The market simply adapted to the increases and carried on. That’s where the central bank brings the two-by-four 2×4 into action. You have to get the speculators’ attention, whack them when they don’t expect it, and do something they can’t hedge against.

Here’s one way to achieve that: Take back all of the interest rate cuts since September in one go, at a single Federal Open Market Committee (FOMC) meeting. Think about it: At 2:15 p.m., the customary announcement time, Federal Reserve Chairman Ben S. Bernanke discloses that the Federal Funds target has changed from 2% to 5.25%.

That ought to do it!

But what would happen to the U.S. housing market, whose struggles were the main reason why rates were slashed to begin with? After all, a little inflation is helpful; if wages follow prices, pretty soon everyone is earning more in money terms, house prices don’t look so high, and the market can recover.

But with oil and commodities prices zooming up as they have, this comforting concept just doesn’t work. Instead of getting richer, U.S. consumers are paying out more and more of their incomes to fill their tanks and feed their families. So in terms of spending power, they are getting poorer. Their ability to buy expensive housing is diminishing, not increasing.

Fannie Mae (FNM) said early last week that house prices across the United States could drop by an average of 25%. That’s a huge amount. Such a decline would basically mean that all the mortgages taken out in the last five years would be underwater. If inflation doesn’t bail the system out, then no amount of cheap financing is going to rescue housing. The mortgage market, Fannie Mae and its sister Freddie Mac (FRE) all are financial roadkill. Perhaps the U.S. government will rescue them, but there’s no prize for guessing who will pay for that!

Based on reported inflation, the Fed is likely to start increasing interest rates by small amounts at one of the next two policymaking FOMC meetings. If the Fed or the politicians start panicking about oil prices - as they well may - the central bank can solve that problem by increasing rates much more sharply. And the best time probably would be between FOMC meetings, when nobody’s expecting it.

Either way, interest rates are headed higher.

If that’s your expectation, too, it’s probably a good time to look at the Rydex Juno Fund (RYJCX), which takes a short position in Treasury bonds and, therefore, benefits when rates rise and Treasury bond prices fall.

Source: With Oil Speculators Blitzing, the Fed Needs to Call an Interest-Rate Reverse Play

Pages: 1 2

Pages: 1 2