Is the Fed Setting the Stage for Another Financial Meltdown?

The question most investors are asking these days is when will interest rates go up? But I am here to say that when they do money market funds may become too risky for many of today’s savers.

Traditionally, the saving class and those anticipating fix income payments are the ones who benefit from higher rates but suffer when rates are low for a considerable time. What some fail to consider is the question of new issue bonds with fixed income payments or existing debt with established fixed rates.

For example, if you are an investor sitting in cash waiting, you are waiting for rates to increase on new issued IOUs before locking in a rate to be paid back over time. But if you own a 10-year U.S. Treasury bond at 2.65 percent and are collecting interest payments semi-annually or quarterly you will experience a drop in the value of the price of the bond as rates increase. Psychologically this feels painful as you think you are losing money on the bond you own. This is only true if you plan to sell the bond and don’t see it to maturity.

This is exactly what happened this past summer as the 10-year bond yield went from 1.6 to 3 percent within a short period of time. This was a “shot over the bow” by Federal Reserve Chairman Ben Bernanke who was testing the waters for higher rates.

Federal Reserve Bank Chairman Ben Bernanke delivers the Herbert Stein Memorial Lecture during the National Economists Club Annual Dinner November 19, 2013 in Washington, DC. Bernake spoke on the subject of ‘Communication and Monetary Policy’ and answered prepared questions. Photo Credit: Chip Somodevilla/Getty Images

For all intents and purposes this warning shot did nothing but confuse the market and increase fear about the future readjustment of rates.

So how should an investor be positioned, to ride the upcoming wave of rate hikes?

Traditionally, the asset class which worked well in similar environments was floating rate instruments. These funds today are “not your father’s funds”.  These vehicles produce a higher rate of return than money market funds but when you look under the hood you find a souped-up portfolio which may be more aggressive and risky than first thought.

These managers are reaching for yield in low quality securities, and in addition may be purchasing them with credit (leverage). In their defense, in exchange for this increase risk, these managers are offering a higher yield to attract more assets, at the same time, the supply of “cash like-investments” has been declining ever since the financial crisis of 2008. This lack of supply has piqued the interest of the Federal Reserve and the U.S. Treasury.

By the Fed keeping rates low for the past four years the debt markets have shown signs of dysfunction. This is what happens when a large entity like the government or Fed Bank crowds out participates of a natural free market.  The Fed is reported to be participating in up to 90 percent in our Treasury auctions. The issue is the short term debt supply has been declining and may start to affect the commercial paper market eventually.

Stacks of money move through a machine during the phase of production where the new 100 USD bills are applied with a serial number, a US Federal Reserve seal, are cut and stacked at the US Bureau of Engraving and Printing’s Western Currency Facility October 11, 2013 in Fort Worth, Texas. AFP PHOTO/BRENDAN SMIALOWSKI

This is a perfect example of “the drug that can save you will kill you in the end”.

Being aware of this fact: The Fed started to look for ways to increase the supply of short term debt instruments while together increasing the reach and power of the Federal Reserve Bank in case of a financial meltdown 2.0.

The result is the issuance of the Floating Rate Notes (FRN), the first U.S. Treasury security issuance since Treasury Inflation Bonds (TIPS) in 1997.  These Floating Rate Notes are to be introduced Jan. 29, 2014 and will be overnight instruments which will have a floating Net Asset Value instead of a fixed rate and will be bench marked to the 13-week Treasury bills.

This seems like a good idea on the surface, having more options and increasing supply. But the devil is in the detail when you look closer as to who will be mandated to purchase these FRN and what implications it may have on the average investor.

What if I told you that your money market fund will become your riskiest part of your portfolio, would you be concern?

Well the jury is still out on the implications of the Fed introducing risk into an area of the market which has traditionally been one of the safest places to be. In my next piece I will explain how Floating Rate Notes will be the way the Fed “comes to the rescue” when or if the markets experience a freeze up in credit or we experience  a no-bid market as a result of the U.S. debt default which could come as early as February 2014.

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