A New Income Era

The Federal Reserve announced last week that it will lift interest rates for the first time in nearly a decade, which, I’ll admit, was a bit to my surprise.

Not because I didn’t think Janet Yellen, the current Fed chair, had the so-called courage to act, but because the market environment is extremely fragile. I don’t believe it can weather a series of interest-rate hikes … and Yellen herself seems to hold a bit of doubt.

For that reason, I predict that this rate hike will yield one of two results: a market crash, or a stagnant market. And if it’s the latter, it will last for years.

That’s why our strategy includes a plan to make money when the market is volatile — and even when it’s down. We’ve taken the proper precautions in our portfolio by adding protection, and I’m planning to add a new position soon.

But back to the repercussions we can expect from the rate hike…

If you’re not aware, the Federal Reserve has a dual mandate from Congress: to maintain full employment and stable prices. Any action the Fed takes must be to achieve these two results.

But with the Fed openly stating it doesn’t believe we’re at full employment yet and with the country running below the Fed’s 2% inflation target (an indicator of stable prices), it’s hard to believe raising rates helps us achieve those targets.

During the press conference, Yellen was even asked how raising rates would help the Fed achieve its mandated goals, and her response was mixed.

Her immediate answer was that she wanted to be able to react to a negative shock in the market. By raising rates, she effectively gives the Fed a few moves, i.e. lowering interest rates, before going back to unconventional methods of Fed policy, such as negative interest rates or more quantitative easing.

She followed that up with the exact opposite view: She was concerned the market would overshoot the Fed’s targets of full employment and 2% inflation, causing the Fed to raise rates abruptly — which would ultimately kill the economy’s momentum and send us back into a recession.

Clearly, these are two starkly different responses to one important question, signaling the Fed isn’t certain about the economy’s future.

More importantly, the Fed isn’t supposed to raise rates just because the markets expect it — which I think was part of the case here.

There has to be a rationale, which historically has been that the market is strong, inflation is meeting its target and employment is nearly full. By tightening its monetary policy (raising rates), the Fed helps keep the economy from “overheating” and stabilizes prices and employment at the correct levels. That’s clearly not necessary in today’s environment. We have theoretically run “underheated” since 2008, with inflation running modestly below its target and the labor market slowly improving (at least on the surface) — and I don’t think we are close to overheating yet.

So with all that in mind, we can expect one of two scenarios from this ill-advised rate hike…

On the Cusp of Collapse

The Fed’s latest action means we have entered a new era of interest-rate hikes. Mind you, every previous cycle of rate hikes was months or a few years before a major market collapse. We saw it in 2006, when a rate-hike cycle ended — just a few years before the crash. A rate-hike cycle also finished just before the 2000 dot-com bubble. There was even one just before the 1997 Asian currency crisis. Every time the Fed goes through a tightening cycle, it helps trigger a collapse.

If the Fed follows its projected rate-hike schedule — with several hikes over the next year, ending in a rate of 1.375% by the close of 2016 — we’ll be on the cusp of a similar collapse.

That’s what we want to be prepared for. Not only to benefit from the coming market volatility, which normally picks up when a rate-hike cycle commences, but to have significant capital to put to work once prices come tumbling down.

There is, however, another scenario I see playing out.

If the Fed ends up reverting to extremely accommodative policies by either lowering rates or restarting quantitative easing, we won’t get a market crash. Instead, we will be stuck with a stagnant stock market for likely a decade, with practically no returns for investors holding ordinary stocks.

Either way, the rally we experienced from 2009 to today is just about over, and income will be our only real source of growth, making unique strategies like the ones we use in Pure Income critical.

This is all part of why we’ve been taking precautions in our portfolio by adding protection to our long positions, focusing on income and implementing a strategy that generates income even in a down market.

I don’t have a new trade for you this week, but I wanted to take some time to update you on what to expect in the coming months as well as coming years. Next week, we will make some adjustments to our portfolio, including adding a new position.

Our portfolio now holds two new stock positions — Spectra Energy Partners (NYSE: SEP) and Senior Housing Properties (NYSE: SNH) — which were put to us last Friday. Both rallied higher early this week and are now only slightly negative, down 1% and 4.5%, respectively. I will continue to monitor them and alert you when any action is needed, either to add protection or collect income using covered calls.

So pay close attention to your inbox next week.

In the meantime, I wish everyone a wonderful Christmas and a happy holiday.

Regards,

Chad Shoop
Editor, Pure Income