How to Prepare for Higher Rates

It was already a busy month just two weeks into November when we released the latest issue of Peak Income to subscribers.

Before embarking on a trip to Asia, President Trump had nominated Jerome Powell to replace Janet Yellen as Chair of the Federal Reserve, and not long after Republicans in the House of Representatives introduced a tax reform bill that could, well, change a lot of things. The Senate has since followed suit with its own proposal.

For our purposes in Peak Income, both bits of news are positive for our income-generating approach, as I detail in the issue. While tax reform is still very much a fluid situation, I want to share with you today about why the Fed news is particularly well suited for us.

Tapping Powell as Fed Chair is seen as more of the status quo. He’s a member of the Fed’s Board of Governors and was widely viewed as the safe choice and the pick that Wall Street wanted. That’s good for us. We’ve done just fine under Yellen, and I expect more of the same under Powell.

John Taylor, the other Fed Chair finalist and a respected economics professor at Stanford University, was seen as a lot more dogmatic about raising rates at this point in the business cycle.

He suggested that rates should be three times higher than they are today (3.75% versus 1.25%). Had Trump nominated Taylor over Powell, things would likely have gotten dicey in the bond market. But we don’t have to worry about that.

I think Powell will likely continue Yellen’s slow, gradual approach to normalizing monetary policy.

But the market is expecting Yellen to give us one more rate hike on her way out the door.

And I’m betting that Powell will want to prove his bona fides by giving us at least one rate hike immediately after taking office in February.

No Fed chair wants to start the job looking weak, so a quick hike will allow Powell to establish authority.

We should expect short-term rates to go higher for a while.

Yet, rather than rise in anticipation of this, floating-rate funds have spent virtually all of 2017 drifting lower.

This creates a nice opportunity to capture a high current yield today while getting the potential upside of floating rates essentially for free.

We already have a little exposure to floating-rate securities via a fund that we’re up about 14%, and I expect more gains to come.

But this subsector is attractive enough to warrant the addition of another position, and I’m recommending one of the largest and most liquid funds in this space.

The great thing about this floating-rate fund is that it’s a nice addition to a fixed-income portfolio because they tend to have minimal correlation to the broader bond market.

Consider the past year.

Most bond prices tanked after last year’s election, as the market expected the incoming administration’s policies to be inflationary. But, within months of Trump taking office, bond prices started to firm up again, as it became more and more obvious that the wheels of government would continue to turn slowly.

For most of 2017, bonds have performed exceptionally well, taking a lot of investors by surprise. (Though not us, I can proudly say; I’ve consistently written over the past year that the post-election bond rout would be a blip and nothing more.)

Yet floating-rate securities have experienced precisely the opposite. Prices surged after the election in anticipation of the higher rates that would follow imminent inflation. When inflation failed to materialize, money started to leak out of the sector.

Today, a year after the election, the fund I’m recommending to my subscribers is right back where it started. It’s a great value that I expect to return anywhere from 17% to 27% and give you consistent income, a bedrock of anyone’s retirement plans.

You can think of this floating-rate investment like a free bonus option. If rates stay more or less unchanged, the “option” expires worthless. That’s OK, as we didn’t exactly pay up for it at today’s prices.

If the Fed pushes short-term rates significantly higher, great! Our “option” kicks in.

In one case, we win… and in the other, we don’t lose. Those are odds I’m happy to take.

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Charles Sizemore
Editor, Peak Investor

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Categories: Interest Rates

About Author

Charles Sizemore is a research analyst with Dent Research. His primary research focuses on income, retirement strategies and fundamentals.