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After two years of tight credit that has reduced sales growth for American
companies to a crawl, housing is the only sector of the economy
that's still growing. Not surprisingly, real estate and bonds are
the only investments that are still making profits. Now the Fed
wants to strangle housing, too.
Speaking at an industry regulator symposium, St. Louis Fed President William Poole warned an industry group that mortgage giants Fannie Mae (nyse: FNM - news - people ) and Freddie Mac (nyse: FRE - news - people ) don't have enough capital to weather potential financial disruptions and that we need to increase their capital requirements to avert a catastrophe. On the heels of Warren Buffett's remarks about derivatives--used in the mortgage industry to hedge interest rate risk--Poole's remarks had a chilling effect on the market. The market cap of Fannie Mae and Freddie Mac declined by $6.5 billion. Why don't the policy makers just keep their mouths closed and their minds open? This is no time to further frighten people, their trust already worn thin by the tensions of the past two years. We are about to go to war in Iraq with little support from our allies in Western Europe. North Korea is testing missiles in the Sea of Japan. Markets are thin. Economic activity is very, very fragile. Investors are dumping stocks, corporate securities, mutual funds. They have put the proceeds into money market investments, bank accounts, government bonds. This fear-driven flight to quality has driven the ten-year Treasury yield down to 3.57%. Five-year notes (2.48%), two-year notes (1.34%) and three-month T-bills (1.06%) are even lower. All this gloomy talk is head-faking investors into making the wrong moves. Treasury securities can give false security. Treasury securities are risky, too. Not many investors know this. Not the principal and interest payments--you will get your interest check in the mail and your principal back in five, ten or 30 years. It's the price. Whenever people decide it's OK to come out of their bunkers again--and they always do--they will see that they can do better owning other investments. They will sell their Treasury bonds and notes; prices will fall. That safety will turn out to be an illusion. Here's an example. The 30-year Treasury bond, issued with a 5.375% coupon, sells today for $111.34, a yield of 4.65% per year over its remaining life until February 2031. If the yield rises by even 100 basis points, to just 5.65%, the bond price would drop to $93.92, a loss of 15.6%--more than three years' income. If rates rise more than that, your loss would be bigger still. You can reduce this risk by reducing the maturities of the bonds you own, for example, by buying Ishares Treasury Bonds (amex: SHY), the one-to-three-year Treasury exchange-traded fund, and by owning corporate debt securities--corporate bond prices are not as inflated--instead of Treasuries. There could be one more drop in equities and one more rise in government bonds but all the pros I know are getting ready to move from bonds to equities after the big selloff is complete. When will that be? As soon as the uncertainty over Iraq ends. Don't be caught holding the bag full of cash and government bonds when that happens.
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