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Bond Market: Four Ways to Hedge the Looming Fixed Income Fiasco

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The worst global bond rout in nearly 20 years is on the horizon, but it doesn't have to hurt. In fact, you can turn it into such a big profit that even the inflationary pressures will seem like a minor nuisance.

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Editor's Note: Keith Fitz-Gerald is the chief investment strategist for Money Morning, an online investment research site.

Many investors are afraid of inflation because they understand the run-up in prices will take a big bite out of their wallets -- and their buying power.

While that's a valid concern, I'm much more worried about one of the other possible fallout effects of the expected inflationary surge -- the potential for the worst global bond rout in nearly 20 years.

But here's the thing: Even if that happens, it doesn't have to hurt. In fact, you can turn it into such a big profit that even the inflationary pressures will seem like a minor nuisance.

Deja Vu All Over Again

The last time we experienced anything like this was back in 1994. And the surrounding circumstances at work back then were remarkably similar to those we face now. Bond yields were at historical lows that year, company wages were flat, and we were in the midst of an unprecedented 34-month economic expansion.

Fortune estimated at the time that yields on the 30-year US Treasuries -- which rose from 6.2% at the beginning of the year to 7.75% by September -- cost US bondholders more than $600 billion and global bondholders as much as $1.5 trillion. (Those losses are listed in 1994 dollars; if we convert them into current-day dollars -- even using the federal government's dubious inflation statistics -- those losses would be $888 billion and $2.2 trillion, respectively.)

I grant you that those are staggering numbers. But they pale in comparison to what's on the line today.

As I noted late last month, the total value of the global bond market is presently estimated to be $80 trillion, with the US accounting for roughly $31 trillion to $34 trillion -- or 39% to 43% of the world's securitized debt.

Investors constantly tell me that "things are different now," and insist "this could never happen today."

As the late great investor Sir John Templeton liked to say: "The four most dangerous words in investing are: 'This time it's different'."

In fact, I'll even say this: Investors who claim we could never have a reprise of the 1994 global-bond-market meltdown are deluding themselves.

We are today securitizing ever-larger chunks of the global economy with everything from credit-card debt to home mortgages -- which we're then selling into larger and larger pools of assets.

The upshot: There are now trillions of dollars of "derivative" assets involved in the mix, and the bond markets are no longer the "safe haven" investors have long thought them to be. In fact, this once-stodgy hangout for fixed-income investors have been transformed into huge speculative pools for the self-anointed Wall Street "masters of the universe" who traded the rest of us to the brink of financial oblivion in late 2007, and who are once again on the hunt.

The Farcical Fed?

I'm not alone in this view, with such investing notables as Dr. Marc Faber, Jim Rogers, Pacific Investment Management Co. LLC's Bill Gross, and others all observing the potential for a massive correction once traders take interest rates into their own hands.

In fact, JPMorgan Chase Chief Economist Bruce Kasman -- a former Federal Reserve Bank of New York official -- told Bloomberg News that "there is a recipe for disruptive dynamics in markets if policy adjustments have to gather steam in a synchronized way."

Put in plain English, bonds could get clobbered if traders doubt the capabilities of the US Federal Reserve -- and if the US central bank is forced to start raising interest rates before policymakers really want to do so.

When I've warned of this scenario in the past, I characterized this as a "potential" outcome. Now it seems like more of a certainty. The only question is: When?

Most investors acknowledge this -- even if that realization is hidden in some deep, dark recess of their brains. But what many are missing in their quest to second-guess the Fed is that, this time around, the catalysts are events that are actually taking place thousands of miles from our own shores.

As I've noted on several prior occasions, the only reason we've been able to stave off inflation in the face of $14 trillion debt and a Fed that wants to keep interest rates artificially low is that our nation has been able to offload inflation to China, India, and other emerging-market economies where monetary policy could absorb our own special brand of export: fiscal lunacy.

Ironically, this has all been okay at least as long as the developed world kick-started everybody else. But now that the emerging markets represent one-third or more of the world's economic might, you have a very different story.

For instance, it's no longer inconceivable if things really get out of hand that yields on our own 10-year Treasury notes could zoom to 10% in the next 24 months, an increase of 183% from the 3.53% yield the notes were trading at on Monday. The odds of such a scenario aren't high. But it's not impossible, either.

My "trader's forecast" stands as a complete contradiction to the expectations of Team Fed and legions of economists who are forecasting a subdued bond-market decline that sends yields up only to 4.25%, according to Bloomberg.

The way I see it, the tiger has already escaped his cage and is on the prowl. Fifteen of the 20 emerging-economy countries my team and I watch are already raising rates to cope with higher inflation -- chiefly the food and oil prices that are either nearing, or in, record territory.

Normally, raising rates in the face of inflation is a good thing. But the danger here is that the central bankers around the world aren't raising rates enough -- particularly in the China-dominated Pacific Rim. And that could come full circle to bite US investors.

According to Bloomberg data, eight of 14 countries in the Asian-Pacific region are running negative real interest rates. This is especially problematic because a negative real interest rate means that the rate of inflation is greater than the central-bank-set interest rates.

This matters -- and hang with me on this -- because negative real rates, although relatively rare in the annals of global financial history, essentially steal money from savers in order to "subsidize" debtors. Over time, this engineers an involuntary redistribution of wealth from those who have been responsible with their assets to those who haven't.

You see, central banks tend to manipulate interest rates in the interest of self-preservation -- especially when it comes to the short-term interest rates that are arguably the most "controllable." In practical terms, these central bankers will drive short-term rates down below the prevailing rate of inflation, which means that savers actually lose real purchasing power -- hardly a reward for the savers' prudence.

I'll admit this is a pretty abstract concept, so here's an example that might help. If you lend $10,000 in 2011, it might be worth $10,100 in 2012 -- even though the same money is only capable of purchasing $9,900 worth of goods or services.

And that leaves investors in quite the pickle: Should they "lend" money to those who will squander it, or do they hoard their cash in an attempt to save it from central bankers and politicians who don't seem to understand (or even care) that giving money away ultimately destroys our economy as well as the economies of our trading partners?

History shows the Fed is pretty much damned either way. If it continues to take money from the private sector under the guise of engendering growth, it risks crushing investors via short-term rates that will ultimately rise. Everything from adjustable-rate mortgages (ARMs) to credit-card debt will be affected.

If the Federal Reserve doesn't raise interest rates, the money that US President Barack Obama and Team Bernanke desperately want spent here will continue to migrate to other capital markets where interest rates are higher (and rising) and more reflective of actual growth.

Moves to Make Now

Negative-real-rate environments traditionally support investments in gold, silver, and other commodities because assets of those types help hedge the very real loss of purchasing power that accompanies them. Agricultural choices are solid, too -- especially with food costs at record levels around the world.

Two of my favorite investment choices of this type are the SPDR Gold Trust Exchange-Traded Fund (GLD) and the MarketVectors Agribusiness ETF (MOO).

I also happen to like exchange-traded notes (ETNs) that are tied to the Rogers Commodities Index created by the aforementioned legendary investor. Two include the Elements Rogers International Commodity Index Total Return ETN (RJI) and the Elements Rogers International Commodity Energy Total Return ETN (RJN).

I know that the run in such choices has already been significant with gold trading at near-record levels, oil punching through new highs almost daily, and agricultural commodities also flirting with never-before-seen prices in many parts of the world, but the fact that we have seriously negative real rates of return around the world suggests we'll continue to see growth in those asset classes for some time to come.

Then the real fireworks will begin -- when everyone else realizes we've all been had by misinformed central bankers who thought they understood the laws of money and who enabled the very conditions that will make $200 a barrel oil and $2,500 gold seem like bargains in the rearview mirror.

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No positions in stocks mentioned.
Fifteen trades. All profitable. Since launching his Geiger Index trading service late last year, Money Morning Investment Director Keith Fitz-Gerald is a perfect 15 for 15, meaning he's closed every single one of his trades at a profit. And he did this during one of the most volatile periods for the U.S. stock market since the Great Depression. Fitz-Gerald says the ongoing financial crisis has changed the investing game forever, and has created a completely new set of rules that investors must understand to survive and profit in this new era. Check out our latest insights on these new rules, this new market environment, and this new service, the Geiger Index.

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