The Best Investments for Rising Interest Rates

October 4th, 2014
in contributors

Article of the Week from Money Morning

by Keith Fitz-Gerald, Money Morning

We're entering a rising interest rate environment for the first time in 33 years.

This is a watershed market event - a shift really - that will change how you invest. In a moment I'll explain what it means for your money and detail three of the best investments you can make now to protect yourself and profit.

Follow up:

But first I want to show you why I'm so certain, not only that rates will rise, but what is going to cause it.

It all comes down to one number.

The Market's "Truth Serum"

The 10-year Treasury yield serves as the "truth serum" for the markets. That's because bond prices and yields have an inverse relationship: When yield is falling, that means that the price of bonds is rising.

At the same time, so is risk.

Many people don't think of rates this way, but they should because rates reflect overall economic conditions. The higher the risks, the more premium needs to be attached to convince investors that U.S. bonds are worth owning.

If that doesn't make sense, think about it this way. Bond rates are a lot like insurance premiums. You and I probably have pretty cheap premiums because we've been driving for years. But try pricing out a 16 year old with no experience in a sports car - the risks are a lot higher that he'll have a fender bender so the premiums charged to insure him are higher too.

This makes sense if you look at the "yield curve" covering everything from near-term bonds to those that mature 30 years from now. It's far harder to predict events 30 years from now than it is 2 months from now, so the "yield" is normally higher to compensate for the unknown risks between now and then.

best investments for rising interest rates

So why is the 10-year so important?

There are any number of reasons, but what you need to know is that the 10-year Treasury is among the world's most liquid financial instruments.

It's traded by virtually every institution in the world, has exposure to global risk and the global economic outlook, and by implication is related to the staggering derivatives market that is an estimated $1.5 quadrillion deep at this point. As such, it's a proxy for the world's hopes, fears, and aspirations.

More to the point, the 10-year yield tells you everything you need to know about what's going on behind the scenes. There's simply no other indicator with such power. I say that because with an aggregate value approaching $100 trillion, the bond market is five times bigger than the stock market.

So forget the policy wonks and even Yellen. If you want to know what the men and women who make trillions of dollars in decisions daily with real money are thinking, this is the only number you need to know.

When traders are clinging to bonds, as they have been recently despite a White House that's desperate to prove to America that things are improving, it tells you that they're shoring themselves up for a coming downturn rather than positioning themselves to rake in returns during the good times.

This is why you've heard me talking about how "stubborn" the 10-year yield has been for months now.

This suggests that investors and traders alike see the overall economic picture for the U.S. as an increasingly risky one. It's also an unmistakable sign that the Federal Reserve risks losing control. And, finally, it reflects an utter lack of confidence in the Fed's low-interest rate policies, as reflected by a drop in the 10-year yield from a high earlier this year to a low of 2.40% a few weeks ago. Since then, the yield has recovered to 2.52% as I write this, but that's certainly nothing to write home about.

This lack of control over the Treasury's tumbling 10-year yield makes our financial system vulnerable to attack. Unfortunately, when I see this weakness, I know that derivatives traders do, too. The Fed also has to be well aware that at some point, a gang of derivatives traders or a Soros-like figure will call its bluff and massively short our currency, leaving the U.S. economy - and Yellen's legacy - in free fall.

Yellen and her advisers know full well what has happened before when a government leaves it to outside forces to re-introduce them to fiscal reality. In 1992, George Soros famously "broke" the Bank of England, betting that the government couldn't fight market forces indefinitely by propping up the pound's fixed exchange rate. Yellen knows that outside forces could call a similar bluff by her Federal Reserve, massively shorting our currency via derivatives bets that force higher rates with disastrous results for the U.S. economy and your portfolio.

That's why interest rates have to rise, and soon. If Janet Yellen doesn't do it of her own accord, the risk is that traders will do it for her.

The only question is when. I don't know that answer. No one does. Frankly, it's anyone's guess when the massive game of chicken that the Fed and these traders are playing will end.

But there's only one outcome: higher interest rates. Fortunately, there are steps you can take now to survive any market shock, or even profit from it.

The Best Investments to Prepare You for Rising Rates

The conventional wisdom is that a return to higher interest rates will shock the economy and cause the stock market to plunge. While I don't entirely disagree with this, I do offer some caveats.

Yes, it's true that bond values will tumble dramatically. The housing market will also be in trouble again, as mortgage rates rise around 6% to 7%, reversing a recent rise of home values and creating a downward spiral similar to that of 2006-2009. And the stock market will contract - but not for the reasons everyone thinks, nor probably to the degree that's widely expected.

As widespread as the belief of an inevitable stock market correction is, it actually belies history. There have been 30 economic expansions since 1865 and the median return for the following 10 months when interest rates rose the most was 7.9%, according to Rob Brown of United Capital Financial Advisors. More to the point, Brown's research shows that 80% of the 10-month windows with the greatest rate increases delivered positive stock market returns.

More recently, since 1971, there have been seven periods during which the Fed was raising rates and the markets actually gained an average of 19.21%. So you could easily make the argument that capital is accelerating.

That being said, again, I believe we are in special circumstances. Thanks specifically to the Fed, the market's psychology is addictive personality disorder and compulsive behavior. There is no doubt in my mind that the markets will swoon when the free money is actually cut off, or cut out as the case may be.

That calls for a portfolio built to handle the stress that's going to crater unprepared investors and choices that are imminently defensible.

Tall order? Not really.

By altering your thinking, you can not only get ahead of any massive correction, but use it to build staggering amounts of wealth.

Begin by grouping your money into choices that can be defined in two piles - things that the world "needs" like energy, food, medicine, certain kinds of tech, versus things that are "nice to have" like social media stocks or consumer discretionary items, for instance.

To be clear, nothing will be immune from a correction, but history shows beyond any shadow of a doubt that the "must-haves" will be more resilient and come out in far sharper, far more solid shape when the dust settles.

Here are a few of the best investments to make to get you started:

ABB Ltd. (NYSE ADR: ABB) is a global leader when it comes to power and automation technologies. Because it is involved in almost every stage of the development, construction, and implementation of projects that include the building and upgrading power grids, smart grid technologies, and improvement of operations at chemical plants, ABB provides a service that can't be done without. It's reported a backlog of more than $20 billion for the last two earnings reports, which highlights plenty of upcoming demand for its products and services. Plus, the company is paring down non-essential businesses and restructuring, too. It offers a yield of 3.40% - that's more than adequate compensation for your risk as a shareholder.

Becton, Dickinson and Co. (NYSE: BDX) is a company that develops, manufactures, and sells a wide array of medical supplies and devices, instrument systems, lab equipment, and diagnostic products. Because the majority of its products are one-time-use only, it benefits from re-orders on a regular basis. It's also perfectly positioned to grow as the world's population continues to age, and it's recently stepped up its penetration of foreign markets thanks to increased spending on R&D. An added benefit, if you can call it that, is the fact that much of what it provides is single-use supplies and testing equipment which will be increasingly critical in the ongoing Ebola fight. BDX has a 1.90% yield, too.

American Water Works Company Inc. (NYSE: AWK) provides water and wastewater services to residential, commercial, industrial, and public consumers in both the United States and Canada. Because everyone relies on running water no matter what their income looks like, this is the quintessential "must-have" example. Its 2.60% yield will further cushion any future hardship.

I'll be back soon with another column with a few suggestions on how to handle your bond investments.

Believe it or not, they're still a great choice right now, even against the backdrop of rising rates.

More profit opportunities from Keith Fitz-Gerald: You've heard the headlines about how this stock's heyday is over - but the media is getting it completely wrong...

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