The Most Important Financial Development of 2010
Interest-Rates / US Bonds Dec 26, 2010 - 07:04 AMBy: DailyWealth
Dan Ferris writes: Since November 1, long-term U.S. Treasury bonds have fallen 7% in value. That's not supposed to happen. But it's happening.
Since November 1, the municipal bond market has fallen 6%. That, too, isn't supposed to happen. But it's happening.
For most of the last century, the whole world has believed the obligations of the U.S. government – and the obligations of thousands of states, cities, towns, and other municipalities in the U.S. – were the safest investments in the world. These "safe" investments aren't supposed to crash.
The reason U.S. Treasurys and municipal bonds are crashing is by far the most important financial development of 2010.
The crash has affected and will continue to affect the value of every stock, bond, exchange-traded fund... every type of investment there is.
If you've already looked for the reason bonds are crashing, it hasn't been hard to find. This past month, for example, the reason bonds were crashing was on the front page of all the major financial websites. It's been there since November 3, when the Federal Reserve announced it would print $600 billion between now and June 2011 and buy Treasury bonds with it.
On one day last week, the headline at Financial Times' website read, "Fed maintains asset purchase plan." The Wall Street Journal's website read, "Fed Sticks To Bond-Buying Policy." And Bloomberg's site read, "Fed Retains $600 Billion Bond Buying Plan to Boost Economy."
It all means the same thing: The Federal Reserve will keep printing money. The dollar will continue to get weaker. The bond market will continue to fall. Interest rates will continue to rise.
Moody's Investors Services is a ratings agency. It publishes bond ratings. A low rating means a bond is more likely to default. A high rating means a bond is unlikely to default. The highest bond rating is triple-A.
During the financial crisis, Moody's damaged its credibility by giving junky mortgage securities the coveted triple-A rating. Now it's desperate to get some of that credibility back.
U.S. Treasury bonds are rated triple-A, the highest rating there is. But that might be about to change. Moody's doesn't like the implications of the new $858 billion tax cut deal worked out between President Obama and Congress. Recently, Moody's said, "Unless there are offsetting measures, the [new tax] package will be credit negative for the U.S. and increase the likelihood of a negative outlook on the U.S. government's triple-A rating during the next two years."
That means Moody's is thinking about lowering the U.S. government's triple-A rating. The lower your credit rating, the higher the interest rate you have to pay on your debts. The U.S. has about $14 trillion of debt. If interest rates go high enough, it could bankrupt the country.
As usual, the American ratings agencies are late to the party. U.S. Treasurys have already been downgraded to double-A by analysts in two of the largest, fastest-growing emerging economies in the world: China and Brazil.
Brazil's economy is larger than all other South American countries combined. It's an important trade partner with the U.S., China, and many other countries around the world. What Brazil thinks of the U.S. government's credit rating is important.
China is the largest holder of U.S. Treasurys. It has no economic incentive to allow U.S. Treasurys to be downgraded. But it can't afford to ignore reality, either.
Just weeks ago, China and Russia announced they would no longer use U.S. dollars in their trading with one another. And earlier this year, the Bank of China reported a doubling of its gold holdings. Right on the cover of the November 8 issue of Barron's magazine, an ominous subhead reads, "With the dollar more vulnerable, China for the first time is investing more overseas in hard assets, like copper, oil, and iron, than in U.S. government bonds."
That's not what you do if you believe in the ultimate safety and sanctity of the U.S. government's credit rating.
When foreigners start questioning the credit rating of the United States, they're essentially rejecting the U.S. dollar. It's as if a billion Coke drinkers have suddenly decided they're better off with orange juice. Imagine what would happen to Coke's stock and bonds...
In short, the jig is up. The world knows the Federal Reserve is compromising the country's credit rating. The more money the Fed prints, the higher the interest rate bond holders will demand to compensate them for the risk taken, the lower bond prices will fall.
I urge you to sell bond holdings. And I urge you to sell preferred stocks, which face the same problems as Treasurys and municipal bonds. When interest rates rise, these investments decline in value.
If you're an income-focused investor, I urge you to focus on dominant dividend paying companies instead. We've featured a big handful in them in DailyWealth already... and in the coming weeks and months, I'll update you on these ideas... and exactly when you should buy them.
Good investing,
Dan Ferris
Editor's note: Dan is the editor of the 12% Letter, which focuses on safe, high-income opportunities. With four triple-digit winners and 14 double-digit winners, his portfolio is hard to beat. His latest idea is a safe way to pocket a 13% yield. To learn more about The 12% Letter, click here.
The DailyWealth Investment Philosophy: In a nutshell, my investment philosophy is this: Buy things of extraordinary value at a time when nobody else wants them. Then sell when people are willing to pay any price. You see, at DailyWealth, we believe most investors take way too much risk. Our mission is to show you how to avoid risky investments, and how to avoid what the average investor is doing. I believe that you can make a lot of money – and do it safely – by simply doing the opposite of what is most popular.
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Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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