From L Todd Wood, for Birch Gold Group
This is shaping up to be a monumental week. Depending on your interests in life, you may be looking forward to the new Star Wars release, camped outside the movie theater for first crack at the coveted golden ticket.
Or, you could be anticipating the much heralded twenty-five basis point increase in the Fed’s short term interest rate. Either one is likely to be talked about over and over in the press for some time to come.
However, I think it’s telling that we have waited longer for the Star Wars movie than a Fed rate hike.
Birch Gold has written much recently about the consequences of an interest rate hike in this weakened economy. Although, there is one issue that is only starting to be discussed in the financial press that is the weakness in the credit markets and lack of liquidity since the Dodd-Frank bill was implemented.
As an ex-bond trader, I can tell you that life on this part of the ‘Street’ has gotten very difficult. Electronic systems are replacing many trading jobs as it did with the equity markets over the last decade.
However, the bond market is unique. Some bonds are not freely traded and it takes a good trader to know where the bones are buried and how to make sure liquidity in a certain security is adequate. Periods of stress in the interest rate markets make this job all the more difficult.
In addition to technology destroying jobs in the bond market, Dodd-Frank disincentivized large banks from participating in the market. This consequence may turn out to be extremely destructive as the Fed begins to raise rates. Investors holding certain bonds may see the need to sell those securities as a rise in interest rates will make the paper less valuable going forward.
The problem is, with big banks out of the market, there is no one to take the other side of the trade. In the past, hedge funds and such could just sell a large position to a broker, who would take it on their balance sheet and ‘work’ the sale over several weeks or months, limiting the impact on the price of the security.
Now, there is no one to off-load the position to. If you call a large trading desk (if there are any left), they will offer to ‘try and find a buyer.’ If you need to sell right away, to cover a margin call or other financial need, you could devastate the price of the bond. This is what market crashes are made of.
Over the past few trading days, there have been failures of three bond mutual funds at last count, due to this very reason. The liquidity in the market is just not there. I saw in 1994 when the Fed raised unexpectedly, investors who thought they were in ‘safe bond funds’ saw their principal reduced by upwards of thirty percent.
It seems many others are remembering these days as well and are attempting to get their money out. Why they waited this long is a mystery as the Fed has been looking to raise for some time now. However, these funds are now trying to sell bonds and there are no buyers. So they close and go into bankruptcy and investor money is held up longer.
This risk is very real. The Federal Reserve hiking rates will have all kinds of unintended consequences and as with roaches in the kitchen, if there is one, there are many. I can almost guarantee, if three bond funds fail, there will be many more. All of this negative activity could land us in a new recession. The bond market may just be the proverbial canary in the coal mine.
Don’t let your portfolio be destroyed as the markets readjusts. Make sure your savings is protected and back your money with a safe-haven asset such as physical precious metals.
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