Throughout U.S. history American industry has evolved from agriculture, to manufacturing, to services, and now to technology. 

When a transition is complete the last great industry continues to exist in the economy, but grows at a slower pace and becomes a smaller percentage of our national product. Today’s outsourcing (or offshoring) of technology jobs is a sign that America’s current leading industry is about to be replaced by another.  What will replace it? Financing.

Already financial services companies make up the bulk of the market cap of the S&P500. Banks are awash in profits from making all sorts of loans: Credit cards, mortgages, personal and business, lines of credit and the like.

Similar to how the late nineties made a stock watcher out of everyone, the current financing economy has produced a generation of rate conscious consumers. People talk of mortgage rate changes along with the weather, and toss about terms like “refis”, “cash out refis”, “home equity lines of credit”, “interest only”, “option ARM”, “LIBOR, COFI, MTA and Prime”, “hybrid”, “nonconforming” and “5/1” mortgages like they used to discuss sports statistics. Today’s consumer understands a product lineup only credit derivatives bankers would have had familiarity with years ago. Call it the debtification of the lexicon.

Making money off charging interest – not selling or making goods or services – is how many non-financial companies now make a living. The profits GM makes from car sales don’t amount to a hill of beans, the auto giant's big cash cow: financing. One of the largest corporations in the world, GE, effectively operates a commercial bank.

To call interest rates the fuel of the economy would be an understatement. You can get by without fuel. Rates are more akin to oxygen.

For years now investors have been predicting interest rate increases by the Fed. Now it can be told. Wednesday the Federal Reserve did exactly what everyone expected – they raised short-term rates. The Prime Rate – the rate many consumer and business loans are tied to, moved in lockstep as banks readjusted to the new environment.

While investors and market participants affect interest rates too, the Federal Reserve has a large degree of muscle. Fed power is largely over shorter term rates, but they have direct and indirect influence over the entire yield curve (interest rates for various maturities). 

When the powers that be at the Fed feel there is too much excitement in the economy (which could become inflationary or worse, lead to a financial crash) they act to drag the economy down with rate increases and other monetary tightening. 

The last we saw of such tight money policy ended four years ago when the Fed last raised rates in May 2000 at the height of the stock bubble, finishing off a tightening cycle started in 1999. Alan Greenspan and Co. acted to prick an irrationally exuberant stock market and scorching economy. It worked. Maybe too well.

We slipped into a market crash for speculative stocks, and a recession. The Fed reversed course and moved to juice a falling economy, as did President Bush with fiscal stimulus largely in the form of tax rebates and cuts. These actions seem to be working because the Fed is heading back, slowly but surely, to a more neutral stance. Expect the Fed to continue increasing rates over coming months and years. Everybody else is.

Which brings us to our main point: everybody seems to say avoid bonds, favor stocks and really, really avoid longer term bonds as they fall the most when rates climb.

Analysts try to use past data to predict the future. A popular factoid making the rounds is that stocks generally do well after the fed raises rates. Of course, how the economy (and corporate profits) reacted back before financing became our main line of business is less relevant.

As MAXadvisor readers know, we’ve largely missed the troubles on the bond side of our portfolios by avoiding longer term government bonds – the most interest rate sensitive bonds around. Our high yield and foreign bonds have done fine over the last couple of years, and our foray into shorter term bonds has largely panned out at least by avoiding trouble if not earning a mint.

That said, we don’t think stocks are going to kill bonds over the next few years, nor do we think short term bonds are going to be the way to go either, at least not exclusively. We may increase our exposure to bonds in general, and longer term bonds in particular if rates climb a little further.

Blasphemy – buy long term bonds in a rising rate environment?

While the long bull market in bonds is as dead as Dillinger, we may not be at the onset of hugely negative returns for bond holders. In fact, we may see ten year rates kick around the 5-6% for years to come, much as we’ve seen the market drift around Dow 10,000 for years now. The only difference is investors receive 5-6% a year while bond prices drift aimlessly, stock investors 1-2% from their paltry dividend yields. 

Factor in inflation and this is a pretty lousy return, but lousy may be as good as it gets for the time being. This is stark contrast to <a href="https://maxadvisor.com/newsletter/farchives/000017.php ">our pro-stocks, anti-bond stance</a> from over a year ago when 10 year rates were near 3%. You’ll also note our pro bond tone in our <a href="https://maxadvisor.com/newsletter/ffbond.php ">last bond market outlook</a>, written near 5% on the ten year.

It’s quite possible the yield curve will simply flatten out, meaning longer term rates will stay about the same, while shorter term rates will increase. In such an environment investors will earn only slightly less holding a two year bond than a ten year bond. If this happens, investors won’t lose much money in the longer term bonds as the curve flattens – they’ll just earn a better yield along the way. 

In fact, longer term rates would have to rise quite rapidly to erase the benefit of owning bonds that yield 5-6%. Slight increases in rates would only eat a little of that return away. If ten year rates rise to just 6% in three years, investors will actually earn more in longer term bonds then they will in money market funds waiting for rates to climb, even factoring in the loss they’ll take in bond funds as rates climb and prices fall.

Rates would have to really run up, to maybe 7-8% on the ten year, for long term bonds to be a terrible investment compared to cash and ultra short bonds. Could this happen? Most seem to think it can because they are recommending owning cash and short term bonds. This conflicts with a founding tenant of MAXadvisor – the majority are (almost) never right.

Alan Greenspan is a fearful man at heart. Watch images of him on financial TV - you’ll see him look both ways about four times when leaving some government building and crossing a (probably) closed street in Washington. Seriously, this footage makes the rounds on the news almost weekly. Let’s not forget he coined the term irrational exuberance.

And as a fearful man who is completely aware that our leading industry is now financing he will do all in his power to make sure rates do not change dramatically anytime soon. The economy could crumble just as quickly as a drought could send an agricultural economy into depression. 

This situation could mean a bit more inflation then everyone thought we’d get about a year ago when everyone who was anyone was scared of deflation, but it likely means calculated increases that the world can digest. We’ve seen this realization take over in the last few days, as investors realize Greenspan may be taking his foot off the gas, but he ain’t slammin’ on the brakes neither.

The only wildcard is if rates rise dramatically and Mr. Greenspan is powerless to stop it. It better not happen -there are too many people who just plunked down a small fortune to buy a home that has recently inflated in price thanks to low rates. 

Lord help us all if they can’t make these payments and home prices collapse. And you thought the Dust Bowl was bad.