Money and Markets

Dear Friend,

We are crossing a critical threshold beyond which the U.S. government could begin to lose control over rising interest rates, and ultimately, the entire economy.

So I've invited our interest rate specialist, Michael Larson, to join me this morning to help me tell you about the consequences ... the dangers ... and the opportunities.

Trouble is, most people, even many experienced investors, don't really understand interest rates.

First, they think interest rates are strictly decided by the Federal Reserve.

Nothing could be further from the truth. And in the months ahead, interest rates could be driven higher by powerful forces and millions of investors who are beyond the Fed's control.

Second, many people don't understand precisely how investors drive interest rates up.

But it's actually quite simple: Say you have $10,000, and you want to invest it in a $10,000 bond for 10 years. And say you're offered a total of $6,000 in interest for the period. Not bad, right?

But would you be interested if you're going to lose every penny of that $6,000 -- or more? Would you be interested if the $10,000 they give you back is really worth only $4,000, or even less? Heck no!

You'd say: "Either give me a lot
more interest or get out of my face."

That's precisely the attitude of millions of investors everywhere: If they don't like the deal, they don't take it. And if they own bonds that they're afraid will sink in value, they dump 'em or just refuse to buy any more. That alone drives the bond prices down and the interest rates up.

Third, many people don't quite get why falling bond prices always mean rising interest rates.

Reason: That's how bonds are built. A $10,000 Treasury bond is guaranteed to be worth $10,000 when it comes due. So if you can buy it at a discount -- for, say, $9,000 -- that's like earning another $1,000 in interest. The cheaper the bond the more you can make and the higher the effective interest rate.

Fourth, for most people, the biggest mystery is: Beyond just getting a higher yield, how do you profit from big interest rate moves?

Investing in interest rates is entirely alien. They don't know how. They don't know where. The most they ever do is look for the best bank CD or a money market. That's a shame, because we believe very substantial profits can be made in the next few years in the interest rate markets.

In 1980, the Short-Term Treasury-Bill Rate
Zoomed from 6% to 16% in Four Months!

It was the fastest, zaniest, and, for some, the most wildly profitable market surge of all time. Hard to believe, but true. And I remember those days intimately.

Like today, I had a partner who worked with me closely and helped me write my reports. And like my partner today, he was specialized in interest rates.

I'm talking about my father, Irving Weiss.

Dad knew what sometimes causes rates to move in dramatic and massive swings. He often knew what kind of surprises interest rates held in store for us. And he gave us frequent tips on how to transform those surprises into profit opportunities.

One investment, for example, representing interest rate options, could be bought for a meager $500 or less with the potential to control $1,000,000. All you needed was a relatively minor move in rates and the investment could be worth many times more.

Those were Dad's favorite leveraged investments, and they're among Mike Larson's favorites today.

The main difference between them: Dad was several decades my senior. Mike is three decades my junior. But despite the generational gap, I find their views quite similar. And in 1980, Dad said pretty much the same thing Mike is saying now in 2006:

"No one's paying enough attention to interest rates. But watch out: They could rise faster and further than most people think. And when they do you could turn a tiny nest-egg into a not-so-small fortune."

Indeed, when I compare what's happening today to what was happening back then, uncanny similarities pop into my mind almost as clearly as A-B-C:

A. In 1980, like today, a showdown with Iran was a major trigger for surging interest rates, especially when the U.S. embassy in Tehran was taken over by student mobs led by radical Shiite revolutionaries.

Investors feared the crisis would remove millions of barrels of Iranian oil from the world markets.

Ironically, it seems one of the student leaders taking over the embassy was the very same man who is now Iran's president -- Mahmoud Ahmadinejad.

Oil, gold, inflation and interest rates skyrocketed.

B. When the Fed lost control over interest rates in 1980, gold had recently surpassed $700 -- just as it did last week.

Bond investors took one look at surging gold in 1980 and gasped. They were scared skinny that runaway gold prices signaled runaway inflation ... that the inflation would destroy the value of their dollars ... and that the falling dollar would gut the value of their bonds.

So they dumped 'em -- by the truckload. Bond prices plunged and interest rates surged still further.

C. To help convince investors to start buying U.S. bonds again, President Jimmy Carter had to offer the most attractive interest rates in the history of our country -- even more than the rates offered by President Abraham Lincoln during the Civil War.

So Fed Chairman Volcker forced up the official rate (on Federal Funds) by as much as two full percentage points at a time -- all the way up to 20%. Why? He had no choice. That was the only way he could persuade investors he was serious about fighting inflation and the only way he could get them to buy bonds again.

Today, Wall Street squirms when the Fed jacks up its rates by a meager quarter point at a time. Hah! Wait till they see the real fireworks that are possible when the dollar falls and inflation fears run amuck.

Mike believes that kind of extreme situation may still be off in the future. But it's not too soon to start thinking about it. Here's his report:

Fed Chairman Bernanke
Gets It Wrong ... Again!
by Michael Larson

Doesn't Bernanke see the handwriting on the wall?

Doesn't he see what's happening to the price of gold? What about copper, platinum, silver, tin, zinc, aluminum ... and oil?

Who the heck does he think he's kidding? His lame approach to interest rates is going to backfire.

Because of the roaring inflation in commodity prices ... and because of the plunging dollar, investors are now starting to push bond prices down -- and interest rates up -- with or without Bernanke.

In the middle of last year, the price of a 30-year Treasury bond was over 119, or $11,900 per $10,000 in face value bonds. But then it started to fall.

And since the beginning of this year, Treasury-bond prices have been plunging nearly nonstop.

Last week was a case in point. The price of 30-year T-bonds went nearly straight down, falling below 106 for the first time in two years.

The picture is especially alarming if you step back about 12 years and look at the yield (or interest rate) on these bonds.

As Martin explained, when the bond price goes down, the bond yield naturally goes up... and that's precisely what's happening today:

After zigzagging down since 1995, the yield on 30-year Treasury bonds has now turned sharply UP!

Moreover, it has crossed a threshold beyond which millions of investors could start driving the yields even higher as the Fed loses control over interest rates. Indeed ...

Last Week the Fed Did Nothing
To Stop This Dangerous Trend

Last Wednesday, we got another Fed policy meeting, another quarter-point rate hike, and another slice of pie-in-the-sky "happy talk."

To be sure, in its post-meeting statement, the Fed said:

"Possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures."

But in practically the same breath, the Fed claimed:

"The run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation, ongoing productivity gains have helped to hold the growth of unit labor costs in check, and inflation expectations remain contained." (Emphasis is mine.)

Problem: Higher prices for energy, gold and commodities are the very essence of inflation. To continue focusing on this ridiculous, artificial construct called "core inflation" is insane.

The so-called core inflation excludes energy and food. But we all drive, and we all eat.

Moreover, the original purpose of core inflation was not to keep everyone happily in the dark. It was to help weed out special factors.

For example, a drought in California might cause the price of lettuce to surge. Or a railroad strike interrupting gasoline shipments might drive up the price at the pump.

So the Fed would say: "Since core inflation is tame, we don't have to worry about it." And maybe that made sense, for a while.

But not now!

Now, food prices have been going up because of supply and demand. Now, oil and energy have been going up for four long years, also because of supply and demand.

We're no longer talking about droughts, strikes or any other one-time events. We're talking about powerful, long-term forces that should make any reasonable person stand up and pay attention.

And still they're babbling about "core inflation" that's "contained." Give me a break!

No wonder the Bernanke Fed is rapidly becoming the laughing stock of the global capital markets! No wonder bonds are falling and the dollar is plunging!

Interest Rates Rising
Across the Board

Regardless of the Fed's latest machinations, the big picture trend I just showed you is clear. Rates are going up. And they're not just going up a little bit here and there. They're exploding everywhere.

Mortgages? Going higher.

Credit cards and car loans? Ditto.

Home equity lines of credit, personal loans, commercial loans? Same!

Right now, the two-year Treasury note is yielding 4.95% -- the most in more than five years. 10-year notes are close to 5.12%. That's a three-year high. And as I showed you a moment ago, the granddaddy of them all -- the 30-year Treasury bond -- just saw its yield break above a massive downtrend dating all the way back to 1994.

What's fueling this explosion? Three key forces ...

Force #1
The Threat of
Foreign Selling

At the end of 2005, the U.S. Treasury Department owed $8.2 trillion. That means there was $8.2 trillion in U.S. Treasury securities in the world.

Some of those are held by the U.S. government itself -- in various federal accounts and by the Federal Reserve. But strip out all the government-owned Treasuries, and you still end up with about $4 trillion in Treasuries that are privately held.

Here's the big problem: Foreign investors own a whopping $2.2 trillion. That's 55% of all the Treasuries in the world that are not in U.S. government hands.

China holds about $265 billion. Japan has a whopping $673 billion. The U.K., OPEC nations, and overseas hedge funds own hundreds of billions more. Result:

The United States is no longer in control of its own destiny. We've mortgaged, pawned and hocked our nation to foreign investors. And with just a few simple phone calls, they could wreak havoc on U.S. markets.

And why shouldn't they? The dollar is tanking -- and so are bond prices. That's a double whammy for overseas investors.

Let's say you live in France, Germany or Italy. And let's say you take some euros out of your bank account, convert them into dollars and then use those dollars to buy a $10,000 U.S. Treasury bond.

Your money is invested in the United States. You get about a 5% yield. And you're happy. But now, the situation is shifting radically ... and the shift is hitting the fan:

First, the dollar has tanked 5%. So that alone has wiped out your entire yield for the year in just a few months.

Then, to add insult to injury, the value of your bond has also tanked -- about 10%. Moreover, there's no end in sight to the declines.

Next, the same has happened to other investors around the world, especially in Japan. They're the ones with almost $700 billion in U.S. Treasuries. And their losses are piling up by the hour.

Ditto for investors in South Korea, Taiwan and China.

"Why should they sell?" asks Wall Street. Come on! The real question is why the heck shouldn't they sell? It's not like they don't have other alternatives. Like gold, for example.

Indeed, just this week, a leading Chinese expert urged the government to quadruple its gold reserves to 2,500 tons from 600 tons. Can Chinese and other foreign money rush out of bonds and into gold? Absolutely! That's exactly the kind of thing that happened in the early 1980s, and it's starting to happen again!

Force #2
Inflation Feeding on Inflation

Inflation is like an epidemic. Once it reaches a critical mass, it begins to spread at a faster and faster pace.

Bond investors know this. And so when they see the signs, they run for cover. They get concerned that 4% inflation will soon morph into 5% ... 6% ... 7% or more. They sell ... then they sell again.

And make no mistake -- even the so-called "tame inflation figures" you've been hearing about are scary:

• The overall Consumer Price Index (CPI) is rising at a 4.3% seasonally adjusted annual rate. That's already a substantial jump from 3.4% in 2005.

• The "core" CPI I told you about, which excludes food and energy, jumped 2.8% in the first quarter, up from 2.2%.

• These numbers may not look too high to you. But that's an illusion. A major component in the CPI is housing. But instead of using the actual cost of owning a home (which had been going up almost straight up), the government uses rental rates (which had been flat or even going down).

Now, all that is going to reverse as rental rates have started to soar, and you'll likely see the CPI start jumping dramatically as a result.

Bottom line: Bernanke can talk until he's blue in the face about how "well-contained" inflation is. The market's not buying it. And neither am I.

Force #3
Rising Rates Overseas

The Fed has been raising short-term rates since June 2004, and the Federal Funds rate is now 5%, up from 1%.

While that may be all you read about in U.S. papers, there's a lot more going on overseas:

• The European Central Bank started raising its short-term rate in December. We've seen two hikes so far, and more are coming.

• The Bank of Japan is only months, or even weeks, away from hiking rates for the first time in years, too.

• Other central banks in Australia, Malaysia, and Sweden have been raising their rates.

• Even China just increased its benchmark rate by 27 basis points. (A basis point is 1/100th of a percentage point.)

And don't forget what I told you earlier: Foreign investors own more than half of the marketable U.S. debt. So when their interest rates go up, it gives them still another incentive to dump their U.S. bonds and switch the money back to their own investments.

How to Profit
From Rising Rates
by Martin Weiss

Let me pick up from Mike and show you some of the many ways to take advantage of this situation:

1. Short-term Treasuries. For your keep-safe funds, just earn the higher yields as they become available by sticking with short-term Treasury bills or a T-bill only money fund.

2. Inverse bond funds. These mutual funds are designed to go up in value when interest rates rise and bond prices fall. You can buy funds that target 10-year Treasuries or 30-year bonds.

3. Contra-dollar funds. These are mutual funds designed to go up in value when the dollar falls. Most own short-term foreign money markets or bonds, plus other investments such as gold mines.

4. Gold investments. The surge in gold ... the rise in interest rates ... and the decline in the dollar all go hand in hand. So your gold investments should continue to shine in this environment. And with options on gold investments, you can multiply your typical profit potential by three, five, even ten times.

5. Options on interest rates. These give you more leverage than you've ever seen or probably every will see. For just $500, you can still buy options that give you the potential to control $1,000,000. That's effectively 2,000-to-1 leverage with strictly limited risk.

For more information and archived issues, visit http://www.moneyandmarkets.com.

Good luck and God bless!