Don't Fight The Fed: Exploit It

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There's an old saying on Wall Street: Don't fight the Fed.  In other words, if the Fed is raising interest rates to slow the economy, it will, by making borrowing more expensive until it gets so dear that no one wants to borrow any more.  It makes no economic sense to borrow if an investment returns 10% and it costs 20% to borrow the money to make the investment.  In that environment, at the end of the interest rate cycle, investors know that returns will narrow as the expansion has reached its natural conclusion.  In other words, the market will be going lower so get out of interest sensitive stocks.

On the other hand, when the Fed decides to lower rates, it's to encourage borrowing and expand the economy.  That's been the theory until about 3 years ago when loosening started and nothing good happened.  Then the Fed loosened some more.  And more.  And more again.  Until we are now at almost zero rates to borrow for overnight funds and the 10 year note is selling for less than 2%.  We're awash in money.  But nobody's borrowing.  That's because there's no economic expansion that makes borrowing worth doing.  Or the fact that banks need to have more capital and are being stingy with the money they have.  Or the fact that housing prices are only going lower, making them a bad investment for the moment, no matter how low mortgages are (less than 4%). 

So what's an investor to do?  Look at the Fed.  For the first time in memory, the Fed has tipped its hand as to what it will do: nothing.  It won't raise rates (they can't go down as they can't get lower) until 2013 at the earliest.  That means investors don't have to try to guess where rates will go for at least a year.  It also means that any industry that borrows money and lends will have very low costs.  What are those industries?

Start with banks.  Sure, they've been beat up for years, but 2012 could be a break out year.  Most of the large banks (BAC, C, WFC, JPM) want to begin or increase their dividend.  Once the regulators finish with a capital structure plan and banks know what capital they have to work with, these large banks will most likely have a revival as the worst news seems to be baked in at current prices.  They can start a dividend or increase it.  Yes, they still have real estate on their books from defaulted borrowers, but these will be cleaned up over the next year.  And they have to mark these to market so they won't affect forward earnings unless the real estate market goes much lower or they take in a lot more defaulted homes.  Banks should have a good year if they're allowed to pay dividends.

Another sector is Real Estate Investment Trusts (REIT's).  They have to pay out at least 90% of their earnings to maintain tax benefits.  They borrow at market rates and buy mortgages (residential, commercial and carefully how any REIT invests so you don't get any surprises).  When they can borrow at current rates and know that rates won't go higher, they will maintain their spreads for at least the next year.  That means current spreads should prevail unless new mortgages are much lower and spreads between where they borrow and where they lend narrow.  But that doesn't seem too likely as most lending institutions can't afford to make mortgages at much lower levels because they have fixed costs that won't be covered.  That means current yields on REITs should last for at least this year.

Another important note about residential (home) mortgages REITs: there are agency buyers and non-agency buyers.  The agency buyers have Fannie Mae and Freddie Mac mortgages, ones that are backed by agencies that are sponsored by the federal government (known as government sponsored enterprises or GSE...this does not mean it is government backed, like a Ginnie Mae (government national mortgage association)).  Many investors like the level of comfort the GSE provide, and the REITs specializing in them will usually yield less than the non-agency (without any government associated programs).  Some of the current high-yielding REIT's are: CIM (16.7%), NLY (14.3%), AGNC (19.9%), TWO (17.1%), ARR (18.9%). (I own NLY, TWO and ARR.  For more stock ideas, see our income column at

When you see yields like these, they don't come without great risk attached.  So invest accordingly.  Don't buy too much of one and buy several.  To balance these high returns, also add some utilities and drug stocks that have safer but lower dividend yields.

Take advantage of the Fed.  It's stated what it will do for the next year (unless there's suddenly a fast and furious rebound in the will have to raise rates if that happens).  You can buy certain interest sensitive stocks now with the benefit of a most likely scenario: rates won't be changing much this year.  That translates into high yields that should be maintained as the cost of borrowing stays low.

- Ted Allrich
January 3, 2012

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Investing Ideas , Real Estate , Stocks

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Ted Allrich

Ted Allrich

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