Editor’s Note: Folks are getting nervous that the Fed may be about to hike rates. 

After all, it has already met its original inflation target of 2%. It has also already met its original unemployment rate target of 6.5%. 

In today’s Weekend Edition, Bonner & Partners income analyst Jim Nelson reveals why this means big changes in one highly profitable income-investment vehicle. 

He also reveals the unusual strategy he reckons is the single best way to boost your income today…

Everyone has an opinion on what will happen when the Fed finally raises rates. 

Will stocks shrug it off? 

Will they crash? 

You can make an educated guess. But the truth is it’s impossible to know. 

What we do know is that the mere threat of rising rates is already having a profound impact in one unusual, but highly profitable, income-investing vehicle… 

If you’ve been following the news, you’ve probably heard of the $44-billion deal to consolidate the Kinder Morgan family of companies. 

Kinder Morgan is the fourth largest energy company in North America. But it isn’t an explorer, driller, drilling-services company or producer. Instead, it owns interest in or operates about 80,000 miles of oil and gas pipelines. Think of it as a giant “toll road” that picks up fees for the use of its pipelines from energy producers and shippers. 

But Kinder Morgan is also known for pioneering the master limited partnership – or MLP – structure… or at least what modern day MLPs look like. 

If you’re an income investor, you’ll probably already know all about MLPs… 

That’s because they have been one of the best performing sectors in the market. As you can see, MLPs (in blue, represented by the Alerian MLP Index) have crushed the stock market (in red, represented by the S&P 500 Index) as a whole:

If you’re not already familiar with this structure, don’t worry. MLPs are a tax vehicle developed in the 1980s. They are publicly traded – like an ordinary stock – but act as what’s known as a “pass-through entity.” 

MLPs must derive most of their cash flows – about 90% – from real estate, natural resources and commodities. And they must pass their earnings directly on to shareholders… and to the general partners that manage them. If they can pass these two tests, they get generous tax breaks. 

Up until now, the Kinder Morgan group has been made up of two pipeline MLPs, Kinder Morgan Energy Partners L.P. (NYSE:KMP) and El Paso Pipeline Partners L.P. (NYSE: EPB), as well as Kinder Morgan Management (NYSE:KMR), a holding company. 

But the big news shaking up the income-investing world is that Kinder Morgan – in a deal that is set to become the second largest in the history of the energy business – will scrap its MLPs and roll the whole group into a single non-MLP entity. 

This makes sense in a rising-interest-rate environment. Because MLPs retain almost no cash after paying their partners, new builds have to be financed through debt. 

And this is where rising interest rates come into play… 

If its debt costs rise, Kinder Morgan’s ability to expand and grow will be severely impaired. That’s the real business effect of rising interest rates. 

By breaking up the partnership, its new owner will be able to issue new stock… hold back a portion of earnings… and operate these assets without the restrictions MLPs come with. 

That may be good for Kinder Morgan. But income-hungry investors will lose out on a great deal. Kinder Morgan Energy Partners was yielding 5.7% a year — three times what the average S&P 500 stock yields. 

Another potential source of worry for investors in MLPs is political… 

Reuters recently reported that the IRS has temporarily stopped issuing the private letter rulings (PLRs) companies seek when setting up new MLPs. 

There are also signs that MLP’s tax-advantage status is coming under new scrutiny at the Department of the Treasury. 

In response to questions about this from Reuters, a Treasury spokesperson wrote: 

We at Treasury are looking into the effects of these transactions on future tax revenues. 

Instances where the tax base may be eroded serve as a reminder of why we need Congress to enact business tax reform that broadens the tax base and lowers tax rates.

The potential impact of rising rates, coupled with the potential for changes to the tax code, could spell the ruin of this income-rich sector. 

So, what can you do to find alternative sources of income? 

There is a way that is highly unusual – yet highly effective. It’s what the copywriters at Bonner & Partners call the “Instant Dividend” strategy. 

It’s a pretty accurate description, actually. The income from this strategy hits your account instantly. 

Don’t worry: It’s got nothing to do with the bond market. Or bank-loan ETFs. 

And it’s got big advantages over dividend stocks, too… 

The income payments it generates really are instantaneous. So, you decide exactly when to collect. 

Compare that to dividend-paying stocks. These generally pay out on a quarterly basis. That means you have to wait up to three months to collect. 

I even expect “Instant Dividends” to trounce the yields available on existing MLPs. 

Here’s the entire story on Instant Dividends, so you can check it all out for yourself. 

Fed’s Yellen Trying Hawk Costume on for Size!
Is a Rate Shocker Looming?

Today was the big day. No, not the start of football season. That’s still a couple weeks away. I’m talking about the day Federal Reserve Chairman Janet Yellen released her big speech on the labor market in Jackson Hole, Wyoming.

If you’re not a millionaire, high-profile Wall Street economist, media bigwig, Ivory Tower academic, or caviar-and-champagne-swilling policymaker, chances are your invite got — ahem — “lost in the mail” like mine. But suffice it to say, this annual gathering is where global policymakers and central bankers meet amid the mountains and the pristine streams to talk shop.

This is where former Fed Chairman Ben Bernanke unleashed his QE2 experiment upon the world a couple years ago. It’s where the Fed had to face up to the destruction its reckless policies wrought on the housing market a few years before that. And now, it’s where Yellen had a great chance to confirm or refute current investor thinking about future Fed policy.

So what’s my take on her speech? I think she sounded relatively more hawkish … though not a ton more so.

She talked about a lot of the reasons why the weakness in wages and slowrebound in the labor market may be more demographically and structurally driven, rather than cyclical. Or in plain English, it has to do with the aging population, shifts in production overseas and other things the Fed can’t do anything about.

She also admitted the labor market has improved much more quickly than the Fed predicted this year, and implied that could continue. In such circumstances, she said the Fed would have to raise rates sooner than the market expects.

It’s worth pointing out that Yellen wasn’t the only Fed official sounding more hawkish this week. Philadelphia Fed President Charles Plosser got even more hawkishly riled up during his on-site CNBC interview this week. Then this morning, St. Louis Fed President James Bullard — a “middle of the road” guy — said on CNBC that investors were being too sanguine about the risk of rising rates and the strength of the economy.

You know my take: The Fed is way off-sides when it comes to policy, despite some lingering challenges like lackluster wage growth. The tone is shifting as the “Old Guard” policy falls by the wayside. And the risk of a rate shocker — earlier than expected hikes, greater-than-expected hikes, you name it — is increasing with each passing day.

In terms of market reaction today, we didn’t get much out of stocks. But shorter-term Eurodollar futures got hit modestly on the assumption these comments signal the Fed may move sooner than Wall Street expects. As a reminder, those futures fall in price when expectations for Fed hikes increase.

Meanwhile, the euro is really getting slammed (again). It just fell to a fresh 11-month low because these comments underscore the fact the U.S. is way ahead of Europe when it comes to potential tightening. That, in turn, is pushing the investments I’ve recommended to make money from a falling euro higher.

So what do you think will happen next? When it comes to stocks, you could read this news one of two ways. You could say the chance of losing the easy money prop sooner is negative for equities. Or you could say the fact the Fed is sanguine enough about the economy to consider raising rates earlier is positive. Share your take at the Money and Markets website here.

There is another course of action, too. Invest in sectors that don’t rely on the Fed for their well-being … and that shouldn’t get slammed even if the Fed does deliver an interest rate shock.

OUR READERS SPEAK

It’s a busy day on the website, with lots of comments on my latest piece about long-term “Car-gage” loans that look like home mortgages! So let’s dive right in.

Reader Dr. M. said: “I took a car note on a new car (in 2012) for 6 years at a near-zero interest rate. At that interest rate, there is no reason not to stretch it out. Its predecessor was 20 years old (same make and near same model), and one of the best vehicles I ever owned. If this new one turns out to be a keeper, I’ll easily keep it ten years or more — driving it for years after the note is paid off, maybe even handing it down to one of my kids.”

Reader MW added: “If you got the cash, take the zero interest and invest. If you do not, buy the best used car you can for cash or get it on a short-term car loan. I never buy new cars myself, they drop in value too much and are taxed too high!”

In addition, Reader Murl J. said: “I bought a 2002 Chevy Impala, new, with 60 months interest free GMAC financing. Still have it, so we have been driving a paid-for auto for 7 years. We have a very good credit rating and will look hard for another interest free auto loan for as long a term as possible when we buy again. Why not? As a retiree even low return on savings is still infinitely better than 0 interest.”

Good points! If a carmaker is handing out free money, and you’re financially responsible and can invest elsewhere, zero percent loans can work out.

The problem is that many buyers are not responsible enough. They finance too much of the car purchase price. They pay the bare minimum. The car depreciates in value faster than they pay the loan down.

Then they get suckered into buying a new car too soon. They have to roll the old car loan balance into the new car loan, and they sink even deeper into negative equity! That contributes to rising loan delinquencies, defaults, and repossessions. And that’s the real risk.

Still, Reader Ralph notes that the fallout likely won’t be as severe as it was with home mortgages. His comments: “People value their cars much more than their houses. If you lose your house after years of non-payment you can easily rent. Stop paying your car loan and it will likely be repossessed as soon as the creditor calls the repo company.

“On the creditor side, it’s much easier and timely to repossess a car than foreclose on a house. Many used car dealers outfit their cars with GPS locators and charge exorbitant rates, knowing owners will likely default. I don’t think the banks will take as much of a hit as the manufactures as car buyers ruin their credit, used car lots and auctions fill up with repossessed cars, and demand for new cars drops.”

Speaking of the impact on the economy, Reader Jean had some more extensive comments there: “Sub-prime auto loans are a direct result of Fed money printing since sub-prime rates more than cover current repo losses with zero cost of money. What lenders fail to see time after time is that easy financing is a bubble in progress, and they all burst in the end. Easy money cannot compensate for declining growth and declining income in the economy, it’s all based on unsound money.

“The major reason for declining income and declining growth in spending is an excess of increasing debt. The Fed has never allowed the economy to flush itself out and re-boot. Pouring cheap money on the problem is a temporary fix with the same bad results we saw in the housing bubble, and for the same reasons. When will they ever learn?”

Thanks for the comments, Jean. My sense is that the economy is in an OK place now, but that the real comeuppance will be down the road when rates rise and the easy money morphine drip ends. As I said earlier, I think that could happen sooner than many investors realize.

Have a great weekend everyone, and feel free to keep the discussion going at the website!

OTHER DEVELOPMENTS OF THE DAY

 Banks have been paying out fortunes in regulatory and legal settlements, thanks to their actions during the mortgage and housing bubble and bust. But could some bank stocks actually rally now that those penalties are in the past, especially if interest rates start to rise?

This article covers that possibility. My research shows you have to be selective — some financials can actually benefit from rising rates, while others will suffer!

 Merger activity spread to the utility sector today, with Dynegy (DYN, Weiss Ratings: C) agreeing to buy select coal and gas-fueled power plants for $6.25 billion. It’s purchasing those facilities from Duke Energy (DUK, Weiss Ratings: B) and Energy Capital Partners.

 Russia decided to press further in eastern Europe, sending at least 145 of its “relief” convoy trucks across the border into Ukraine today. Ukraine called the move an invasion that occurred without the sanction of the Red Cross. But so far it hasn’t triggered any additional hostilities.

 Speaking of geopolitical tensions, the front page of the Wall Street Journal website was filled with depressing headlines earlier today. They ranged from “Forty Killed in Attack on Sunni Mosque” to “Alleged Collaborators With Israel Killed in Gaza” to “Hostages Central to Islamic State Plan.”

Keep that in mind, as these kinds of tensions have implications for everything from market volatility to oil prices. They also underscore the ramping up of the War Cycles that my colleague Larry Edelson has discussed.

Reminder: You can let me know what you think by putting your comments here.

Until next time,

Mike Larson

The three major indexes all dropped in unison shortly after the release of the minutes from the U.S. Federal Reserve’s July Federal Open Market Committee (FOMC) meeting, reflecting Fed sentiment that accommodative monetary policy could end sooner than expected if improvements continue in the labor market.

At 2:15 p.m. EDT, the S&P 500 dropped 4.13 points, the Dow Jones Industrial Average lost 32.99 points, and the Nasdaq fell 7.66 points, all before the three major indexes began to rise again.

While the Fed made no remarks on an explicit timetable for interest rate hikes, which is what the markets are observing attentively, the minutes did indicate that the situation in the labor market was looking healthier and improving quicker than expected.

The minutes also showed that many FOMC members said “it might become appropriate to begin removing monetary policy accommodation sooner than they currently anticipated” if the economic conditions they monitor begin to converge on their targets.

There also seemed to be language to suggest that inflation would begin to pick up without being derailed by disinflation, as “most now judged that the downside risks to inflation had diminished,” as well as many members believing “risks of inflation running persistently below their objective as having diminished somewhat.”

Here’s what the Fed’s agenda will be for the rest of the year…

The Fed’s Charted Course for Monetary Policy

As the Fed’s playbook stands now, there will be a $25 billion monthly purchase of agency mortgage-backed securities (MBS) and long-term treasuries until the September meeting, when that number will be tapered to $15 billion. And, as minutes from June’s meetings suggest, that last $15 billion will be cut and the policy of quantitative easing will end after the meeting on October 29.

The policy of bond buying began in September 2012 as a way to put downward pressure on long-term interest rates and pour more money into the markets at a time when the U.S. economy needed a quick boost amid a slow-growing, post-recessionary period. It began as a monthly purchase of $45 billion in treasuries, and $40 billion in agency MBS, for a total of $85 billion in total asset purchases.

It wasn’t until December 2013 that former Fed Chairman Ben Bernanke announced that this stimulative policy would begin winding down with a $10 billion reduction in these purchases. With every Fed meeting to follow, another $10 billion would be cut from the purchases until the program was ended altogether.

The only change to that script came in the minutes from June’s meeting, which revealed that rather than cut $10 billion in October’s meeting and continue purchasing $5 billion worth of assets every month until a final round of reductions came at the end of the December meeting, the Fed would just cut the final $15 billion after the October meeting.

All in all, the announcements out of the Fed have been predictable, and current Fed chairwoman Janet Yellen has continued to follow the same path that her predecessor Bernanke handed her when he departed from the post in February.

But even the predictable Fed talk can be felt on Wall Street…

How Fed Minutes Move Markets

Fedspeak, no matter how dry and technical, has the ability to move markets because it gives hints as to what the country’s long-term monetary outlook will be.

Even on days when positive economic news is released, the major indexes won’t move until given direction from the Fed. This happened before the meeting on July 30, when the S&P 500 was down as much as 7.53 points before the FOMC released a statement, despite news of optimistic economic growth expectations. Within an hour of the Fed statement, the S&P advanced 4.56 points.

“The actual numbers are just the latest figures to come out and we always know there’s that next round of numbers,” Clifford Rossi, executive-in-residence and professor of the practice at the University of Maryland’s Robert H. Smith School of Business, told Money Morning. “The Fed is taking this big-picture, long-term view.”

While today is not the day of an actual FOMC meeting, Fed policy dictates that the minutes from each meeting be released three weeks after. Today’s minutes were from the July 30 meeting.

The release of these minutes tends to reiterate Fed policy to the markets, which has been dovish as of late. The Fed has yet to announce when it expects there to be interest rate hikes from their near-zero levels, or when the central bank will begin offloading the more than $4 trillion of assets it has on its balance sheet.

So far this year, on dates when the Fed releases minutes the S&P has moved an average of 8.13 points or 0.2% on the day. While on average this is almost negligible, the S&P’s 7th biggest one-day advance on the year of 1.09% came on April 9, the day of a Fed minutes release.

Is the stock market overvalued like it was before the dot-com bust? Some of the numbers right now are downright scary. Here are some of the concerns over current market valuations and what you can do to profit…

It’s Bull Market in Bonds…The US bond market has hugely out-performed the stock market this year…up ~16%…while the DJIA is flat and the S+P is up ~5%. (Last year was a different story…the DJIA rallied ~22%, the S+P ~28%…and the long bond fell ~15%.)

It’s an even Bigger Bull Market in European Gov’t bonds…yields in many countries have fallen to historic lows…Spanish 10 year Gov’t Bonds have the same (2.3%) yield as US bonds…10 year German Bunds yield less than 1%…2 year Bunds have a NEGATIVE yield.

Historically the bond market has been considered “smarter” than the stock market…so, why the BIG rally in bonds? (Remember last year…everybody was predicting that interest rates would be going up?…well, it’s been 8 years…and counting… since the Fed last raised interest rates.)

Is the bond market up on deflation worries? Yes. Is it up on Geo-political stress? Yes. Geo-political stress is deflationary.

But let’s be clear…this is not your father’s bond market. As David Rosenberg explains, nearly 90% of all US Treasuries issued over the past couple of years have been bought by the Fed, the BOJ and the PBOC. The traditional buyers (insurance companies, mutual funds, pension funds, retirees etc.) are left with “crumbs.” So the signals we get from the bond market are not as valuable as they might have been “back in your father’s day.”

In fact…in the context of “be careful what you ask for”…Central Bank buying may have destroyed a very valuable source of economic intel…the bond market “vigilantes” might have demanded higher interest rates from profligate governments…but under current circumstances…and isn’t it ironic…as countries go deeper and deeper into debt their “cost of funds” keeps falling!

European Deflation:

Several European countries (excluding the UK) are in deflation…with no growth and high unemployment…and now even Germany is sliding into recession…the Euro acts as a strait-jacket and the ECB isn’t helping. Bonds issued by the peripheral countries have had a huge rally…buyers must be assuming that the ECB will finally buy Sovereign bonds  in an attempt to stimulate the Eurozone economies…why else would anyone buy Spanish bonds with same yields as US Treasuries…if they didn’t think that they could unload them (to the greatest fool of all!)…or maybe the buyers simply think that the Eurozone is on the same sort of deflationary path that Japan took…2 decades of deflation…and TINY bond yields…

The weakness of the Eurozone economy leaves it very vulnerable to a shock…the sanctions on Russia…and counter-sanctions…the current escalation of geo-political stress from Russia/Ukraine may be the trigger to dump the whole Eurozone economy into deflation….and since the Eurozone represents ~20% of the global economy we have…

Sputtering global growth:

In July the market began to “price in” a rise in interest rates by early next year….but since the end of July there’s been a sharp reversal in sentiment…the consensus view now seems to be that the Fed will move very slowly.

Despite trillions of dollars-worth of stimulus from the world’s central banks…global economic growth is sputtering….but…

America looks relatively better than the Rest of The World:

Employment is stronger…energy is domestically available…it’s a “safe harbor” in times of stress…the Fed is likely to tighten before other Central banks…

Canada is next door to the USA and may benefit from that to some degree in terms of global capital flows…but given that we expect the US Dollar to rise, as capital (seeking safety and opportunity) flows to America…we see CAD lower against the USD especially because:

Commodity prices are under pressure:

The CRB Index has fallen ~10% in 6 weeks…it’s very close to breaking a 4 year old support level. The commodity market had a great run from 2001 to 2011…while the US Dollar was weak…but now with sputtering global growth commodities are under pressure…any evidence of slowing Chinese demand would be deadly for commodity prices…and weak commodity markets mean weak commodity currencies (CAD, AUD, NZD.) And speaking of currencies…we expect more…

Currency wars:

Cash-strapped governments hoping to remain in office will be very tempted to devalue their currencies…this same temptation may lead to the breakup of the Euro as  peripheral countries (let’s put Italy at the top of the list…thank you, Ambrose) seek salvation via a weaker currency. We foresee the very real possibility of intensifying geo-political stress…intensifying deflationary pressures…and intensifying currency wars…in a vicious circle.

Trading:

We remain long the US Dollar index as a core position. The index is heavily weighted with European currencies and we expect them to weaken into year-end.

We captured the equivalent of 600 Dow points on the late-July/early August break in the stock market…we’ve been on the sidelines waiting for the bounce off the August 14 lows to run out of steam…if the market rolls over we will get short again…looking for a break to take out the August lows…BUT…we have to respect the momentum in this market…it could easily rally to new All Time Highs.  

We’ve written OTM calls on CAD and AUD and will look to get outright short these markets (and NZD) as we expect they will break this year’s lows.

Gold has been very choppy…due to a combination of “chunky” trading and swirling geo-political stress…we think gold could fall in a strong USD environment (and as leverage is wrung out of the markets) but it could also easily spike on a geo-political “flash”…so…we have no position at the moment.

It was interesting to see both bonds and stocks rally this past week. If bonds were “desperately seeking safety”…why did stocks rally? Maybe both markets think that deflationary pressures are so strong that central banks (at least the ECB) will be forced to crank up the printing press…for nearly 2 years we’ve maintained that the last BIG leg up in the stock market began in November 2012 with the realization that Abe was going to win the election and push the BOJ to print money BIG TIME…well, imagine what a boost the ECB could give the stock market if they decide to “crank it up”…and remember that the Yen took a huge fall when the BOJ began printing…well, imagine what could happen to the Euro…

Longer Term Perspective:

The Big Break in the bond market last year brought prices down to the 35 year up-trend line…and they’ve bounced nicely from there…perhaps the long-term rally from Paul Volker’s 1981 lows has just begun another leg higher?