Bond Market Massacre!

By: Money_and_Markets

Mike Larson, here. Two weeks ago, I issued an urgent bond market warning. I said that Treasury bond prices were falling and threatening a critical level of support. If we broke through it, I said, prices could really plunge and rates could take off like a rocket.

Well, guess what? We just sliced through that support like a hot knife through butter. Long bonds plunged by more than a point yesterday. While that may not sound like much, it was the biggest one-day percentage drop in more than 26 months!

You can see the action in this chart …

The 30-year U.S. Treasury bond is now yielding a hefty 5.2%. And in the more closely followed 10-year Treasury market, yields have shot up to around 5.1%. That's the highest since last July.

Bottom line: Fears of inflation, fears of central bank diversification away from U.S. bonds, and fears of a re-accelerating global economy are all combining to drive bond prices lower and interest rates higher .

This is a major, major event in the interest rate markets — one you should absolutely take notice of. My prescription for what to do:

First, avoid interest-sensitive sectors of the stock market like housing and commercial REITs.

I've been harping on commercial REIT's underperformance lately, and my tune hasn't changed. These overvalued, overloved, overowned stocks are still yielding peanuts. Avoid these guys … or better yet, sell if you're loaded up in the sector.

Second, keep your fixed-income money in short-term investments — 3-month or 6-month Treasury bills or something like a Treasury only money fund.

There's simply no reason to go out on a limb with longer-term bonds at the moment. As I just showed you, prices are likely to keep going down. At some point, it will make sense to test the waters. But we're not there yet.

Third, consider pocketing some gains on your high flyers.

Money has been flowing into all corners of the market. And that has helped boost all kinds of asset prices. But higher interest rates could force buyers to become sellers. It's wise to take some money off the table before that happens.

Another threat: Higher rates could put the kibosh on the private equity buyout mania by making deals more expensive to finance. That would further threaten groups like REITs, which have seen a merger and acquisition frenzy.

Fourth, if you haven't checked out the great work my friend and colleague Nilus Mattive is doing in the dividend stock arena, I encourage you to read his latest report . His specialty is ferreting out the kind of high-yielding investments that can survive and thrive in a rising rate scenario, and hand you a heck of a lot better return than what Treasury bonds are offering even now!

Now, I want to talk about something else that's important to me …

Our Contribution to The Housing Debate

There's a movement afoot in Washington. It's winding its way through Congress … the Federal Reserve … major banking regulatory agencies … consumer groups … and trade organizations. Simply put, they're all trying to figure out what to do about the housing and mortgage mess.

The reason is simple: We're in the midst of the most severe housing market downturn in decades, one that shows little sign of stopping.

Some telling figures:

• Existing home sales are off about 17% from the September 2005 peak. The seasonally adjusted annual rate of sales, at 5.99 million in April, was the lowest since June 2003.
• In the new home market, sales have plunged 29.4% from the July 2005 peak. March sales were the lowest since June 2000, forcing home builders to slash prices to drive traffic .
• Most importantly, for-sale inventories have skyrocketed. As of April, there were a stunning 4.2 million existing homes on the market of all property types. That's the highest level ever, and it leaves us with at least 1.7 million "excess" homes for sale, by my reckoning.

You can see why Washington is wrestling with some pretty big questions right now: How did it come to this? How did the housing market explode to such dizzying heights? Why is it falling so sharply now? What can we do to ease the burden on overstretched borrowers? What mortgage practices should be banned? What can we do to avoid meltdowns like this in the future?

For weeks now, I've been grappling with those same questions. You see, I'm working on a special report that we plan to release to the public. It won't be your typical investment bulletin, but rather our company's contribution to the public discourse — an attempt to give policymakers and other interested parties an unvarnished roadmap of the boom and bust … and the best way out.

In a nutshell, here's my take …

Rudyard Kipling once wrote: "If you can keep your head when all about you are losing theirs and blaming it on you … Yours is the Earth and everything that's in it, And — which is more — you'll be a Man, my son!"

Unfortunately, between 2002 and 2006, few in the housing finance food chain took Kipling's advice. Home buyers, lenders, and policy makers lost their collective minds, and their poor choices helped to inflate the largest housing bubble of all time.

The list of contributing forces is long, indeed — overstimulative monetary policy, reckless mortgage lending, a dramatic influx of money into the mortgage bond market, speculative activity on the part of borrowers and real estate investors, and lax regulatory oversight.

To make up for these past mistakes, and prevent them from being made again, we're going to need:

• The right combination of tougher regulation and industry oversight
• Loan modifications
• Fresh thinking at the Federal Reserve Board

And even these measures won't keep the housing market from suffering a long period of weakness — they'll just help make things a bit less painful.

I'm going to put the finishing touches on my report right now, so I'll have more to share with you on this topic soon.

Until next time,

By Mike Larson

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