This Fed Renegade Could Make or Break the Market

Could Thomas Hoenig have a real impact on your portfolio?

You bet he could.

He only has one voice — but it’s a highly influential one. In fact, the last time he had spoke in public on April 7th, the Dow backpedaled 70 points in a matter of minutes.

Mr. Hoenig is the President of the Kansas City branch of the Federal Reserve board. That means he sits with Ben Bernanke and the board of governors to decide the future direction of the nation’s monetary policy.

As such, he not only wields tremendous power over the stock and bond markets, but also has a direct say in how much you might pay for your next car loan. And right now, he’s saying one thing unequivocally: interest rates need to be higher.

The Fed has kept short-term interest rates near zero since December 2008 and telegraphed that they will remain there for the foreseeable future. But those cuts were an emergency measure made during the heart of the financial crisis, and the U.S. economy is no longer on life support.

Hoenig (among others) argue that we need to stop dispensing the monetary medicine — before it causes damaging side effects. He has openly dissented with his colleagues at recent Federal Open Market Committee meetings. He has warned that keeping rates artificially low can, “distort the allocation of resources in the economy and contribute to the buildup of financial imbalances.”

#-ad_banner-#His solution? Raise rates to at least 1.0% to forestall inflation and prevent possible asset bubbles. Hoenig may be hawkish, but he has a point. Loose credit can be a dangerous thing and 1.0% is still relatively cheap, just not free.

Hoenig has also called on Washington to do a better job of balancing the books. After seeing a record $1.6 trillion shortfall in President Obama’s 2010 budget, he warned that fiscal mismanagement could trigger another crisis.

So is any of this getting through to his colleagues? Well, that’s difficult to say. But you can bet they took notice of the latest employment report where payrolls expanded by 162,000 positions last month, the strongest figure in three years. With record high unemployment, the Fed’s hands have been tied. Job creation will give the central bank latitude to begin tightening rates.

Here’s what we know for sure. The Fed has already taken pre-emptive action by raising the discount rate (the overnight rate it charges to other banks) a quarter-point on February 18th. It was the first hike in nearly three years and could signal an increase in the more influential fed-funds rate.

The move is designed to help wean the banking system off the government and back toward the private sector. Most view it as a major inflection point in policy. The collective intelligence of the fed-funds futures market was recently pricing in a 50/50 shot at not one, but two rate increases by the end of the year.

Either way, risk appetite has resumed as the economy has begun to get back on track. Assets are rotating out of safe havens and forcing bond yields higher. The yield on the 10-year Treasury is approaching 4.0% for the first time since October 2008.

Fed rate hikes are like potato chips — you can never have just one. So once the rate tightening cycle begins, expect to see multiple hikes. The last time rates sunk to 1.00% in 2004, they were ratcheted upward 17 times during the next two years, to a peak of 5.25% in 2007.

None of this paints a pretty picture for bond prices, which move inversely to interest rates. During the past year, readers of my ETF Authority newsletter hit homeruns with a number of different bond funds — AllianceBernstein Global High Income (NYSE: AWF), a current holding, has delivered a +151% gain. But I’ve already began recommending they take some chips off the table. You might want to think about it, too.

I could be wrong and the Fed may leave rates unchanged for the time being. But there’s one thing for sure — with rates at zero, the next move will be up, not down. Rarely does the financial world give us anything so iron-clad.

So what can you do to take advantage of the situation?

I would strongly consider floating rate funds (also called senior loan or bank loan funds). These short-term securities have yields that automatically reset every 30 to 60 days. So when rates climb, their payouts march right along with them. In other words, they aren’t just immune to rising rate environments — they actually thrive in them.

Back in 1994, when short-term rates were lifted six times, the average bond fund fell -3.3%, while floating rate funds posted a healthy gain of +6.1%. We saw a repeat performance again in 1999.

I like Nuveen Senior Income (NYSE: NSL), a closed-end fund carrying a yield above 6.3% — it has also topped 99% of its category rivals during the past decade.

If Mr. Hoenig has his way, expect even bigger gains on the horizon.

P.S. Don’t miss Nathan Slaughter’s free online course — The Six Rules Every ETF Investor Should Know… Plus Four Picks for Today.