Editor’s Note: Regular Daily readers know world markets are in turmoil over the Fed’s impending interest rate hike decision. Today we extend our special treatment of the issue with an interview between Tom and Mega Trends Investing Editor Teeka Tiwari. “Big T” has long warned his subscribers trouble lies ahead…


Tom Dyson

Tom Dyson, founder, Palm Beach Research Group: Teeka, the Federal Reserve is almost certain to raise interest rates on December 16.

So the question on everyone’s mind is: What’s going to happen to the markets after that?

Teeka Tiwari

Teeka Tiwari, editor, Mega Trends Investing: I’ve been talking about this for a while. A rate increase will create enormous dislocation across all markets.

It’ll hit the bond market hardest. But it would be naïve of me to say it won’t also affect the stock market.

The first thing we’re going to see is many businesses demonstrating they won’t be able to exist with interest rates at a normal level.

Take [drug company] Valeant Pharmaceuticals. This is its business model: It goes out and pays an exorbitant sum of money for a pharmaceutical company. It then takes those drugs and increases the price tenfold… and makes a ton of money.

But Valeant’s model only works if it has access to very cheap capital… because it’s got something like $30 billion in debt.

In a normalized interest rate environment, businesses like that can’t exist—their financing costs are too great. There are lots of businesses like this right now. And they’re going to get wiped out as interest rates rise.

Tom: Agreed. But you see an even larger downside risk in the bond market, right?

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Teeka: Absolutely. Here’s the problem: When interests rates go up, bond prices go down.

[Bonds and bond-like assets hold an inverse relationship between their prices and their yields. The higher their prices, the lower their yields (and vice versa).]

Since 1982, bonds have been in a bull market. People have done nothing but make money in bonds… because interest rates have been going down. They have no idea that, as interest rates go up, the value of their bonds will go down.

As Janet Yellen raises interest rates, you’re going to see a bit of panic start creeping into the bond market. You’ll see bonds start selling off.

And as we’ve seen—in 2015’s August and September “flash crashes”—there’s just not a lot of liquidity in the markets anymore.

It’s even worse when you look at high-yield bonds… which is where a lot of retirees have moved their money for yield.

The sector is dominated by exchange-traded funds (ETFs). ETFs buy bonds, and then you and I can trade shares of this ETF. We can buy and sell shares anytime we want. Then the ETF has to buy and sell the underlying assets.

In a normal market, that’s easy to do. The ETFs aren’t buying things that are highly illiquid.

But when the market dislocates, it’s like an elephant trying to bolt out of a mouse hole. Everyone’s selling, and there aren’t enough buyers.

It’s panicked selling. And then the buyers just fade away. They will literally not pick up their phones when a trading desk calls them to sell their bonds. The last time I saw that happen was in 1989 and 1990… when the junk-bond market imploded.

You couldn’t get a trader on the phone to sell your bonds. That’s because the minute they pick up the phone—you remember, you were on the bond-trading desk, Tom—you have to take a certain amount of whatever they’re selling. Even if you know it’s going down. As a market maker, you’re obligated. So you’d sooner not even pick up the phone.

So as everybody tries to sell their high-yield ETFs, the ETFs are going to be running to the exits, trying to dump their bonds.

But bonds aren’t liquid like stocks. They don’t trade 100 million or a billion shares a day. They really trade “by appointment.” This lack of liquidity is going to be a major problem.

So you’ll see huge, forced liquidations at really low levels. And it’s going to create panic.

All of a sudden, that “safe” $100,000 you had in high-yield bond funds could be worth $50,000. It could be worth $25,000. When bids disappear, Tom, they disappear. That’s it.

Tom: Yes. It’s like an air pocket.

Teeka: Think about what happened to some great companies in 2008… like American Express. It went to $5. Think about that. This is one of the strongest businesses on the planet. The company’s not going anywhere. It trades for around $70 today. But in 2008, it went to $5.

So now imagine the bond market, which is an order of magnitude larger than the stock market. As the bond bubble—the biggest bubble we’ve ever seen in human history—unravels, it’s going to devastate bondholders.

That’s why—for the last year and change—I’ve warned my subscribers to get out of bonds. Specifically, high-yield (aka “junk”) bonds.

Over the last several years, about a half-trillion dollars has been put into the oil and gas space. Most of it’s come in through junk bonds.

These junk bonds have been issued at these atrociously low interest rates: 5-6%. People think they’re getting a great rate… compared to 0% in a savings account. But junk bonds used to yield 12-15%.

Tom: Right. That’s normal. That’s what they should yield for the risk. But they don’t today.

Teeka: Correct. So here’s my fear, Tom. Here’s the biggest fear that keeps me up at night. I really want to get this message out to our subscribers right now: Get out of junk bonds.

(By the way, Tom, I know you interviewed Porter yesterday and he’s looking to speculate in this area. I agree there will be enormous opportunity here after things start crashing. But if you already own these assets, you need to prepare for them to take a massive dive.)

Let’s look deeper at the situation in oil and gas. We haven’t seen many defaults in junk bonds in this space… even though oil prices are down 60% over the last year.

Oil

That’s because most of these oil companies have hedges on their oil. A year ago—when oil was trading at $90 and $100 per barrel—they sold it in a futures market.

So even though oil is trading around $40 per barrel right now, people agreed to pay $75, $85, even as high as $90 a barrel for oil for future delivery.

This is what’s really saved these oil companies—and their bondholders—this year.

But here’s where it gets very messy: In the first quarter of 2016, more than 90% of these hedges will run off. So now, after a year of being able to sell oil for $75—when it’s really selling for $40—they’ll have to start selling oil at $40.

And Tom, the majority of these small and mid-sized players—the guys who issued all these junk bonds—can’t survive $40 oil. They’ll go out of business.

You’ll see a shocking rain of death fall down out of the oil and gas space next year… the same shock and awe you saw from the housing crisis.

Junk bonds will crush people next year. And they’ll say—just like they did during the housing collapse—“How did we not see this coming?”

Tom, you’ve got to get this message out to as many people as possible. Get out of any junk bonds you’re in. They’re just death.

When the junk-bond market collapsed in the United States in 1989-1990, it filtered through into the stock market. Stocks were down 20% between 1990 and 1991.

It was a horrible market. I remember… I built my brokerage business in that market. We focused on buying quality companies. Then, as the market shook itself out in the latter part of 1991, the market took off again.

So I’m not afraid of the volatility in the stock market. It’ll be an opportunity for us to get quality stocks on the cheap.

But I’m terrified of the volatility in the bond market. That’s because losses you see there will be permanent.

Tom: It sounds like oil and gas will crash regardless of what Janet Yellen does with interest rates. If oil stays at $40 per barrel, nothing can stop that.

Teeka: Yes. Now put these two together: tightening credit plus a junk-bond collapse in oil and gas. That’s a brutal combination.

Tom: It seems shortsighted the Fed’s even talking about raising rates. I imagine it’ll raise rates. It sort of has to now. It’s already “jawboned” it through.

But I can’t see the Fed raising rates further. I certainly can’t see it getting short-term rates back to 3%, 4%, or 5%. There’s no way.

Teeka: The market’s going to move without the Fed, Tom. I’m looking at the 10-year yield chart right now. It’s racing higher.

Once the 10-year yield clears 2.5%—where you see some resistance—the 10-year could leap to 3.5%… without the Fed. Just on panic selling in the bond market.

I know such a big move sounds crazy. So I’ll give you an example.

European Central Bank (ECB) President Mario Draghi announced last week he was not going to increase the size of their quantitative easing (QE) program. German yields on the 10-year bond spiked 35%… in one day.

That’s the kind of move you’d see on a biotech or Internet stock. Not on the debt of the third-largest GDP region in the world. It’s outrageous.

There’s such a lack of liquidity. So I don’t think we can say, “Oh, the Fed can rein this monster in after one rate hike.” The Fed’s going to be playing catch up.

Tom: Interesting. I could see the 10-year rising. But at the short end of the curve, where the Fed controls the rate, [the Fed] will face pressure to keep conditions as loose as possible. Especially if there’s a liquidity problem. And especially if junk bonds start crashing. The Fed will probably do more QE. It’ll put interest rates back down to zero.

How to Survive the Bond Market Collapse

But I take your point. The volatility today is incredible.

In the currency market, for example, the euro’s making its largest move in about seven years. It’s up 3.5% against the dollar. For a currency the size of the euro to make a move like a penny stock… that’s insane.

Teeka: Right.

Tom: It does seem there’s no liquidity in the markets. Even in the currency market—which should be the deepest, most liquid market of all.

Teeka, thanks for your insights. We’ll be exploring the step-by-step specifics of the best ways to navigate this volatile environment in our emergency market briefing tonight. I appreciate your contributions to this effort.

Teeka: Anytime, Tom.

Reeves’ Note: PBRG’s emergency market briefing is tonight at 8 p.m. (Eastern time). It’s 100% free. All subscribers can sign up to attend, right here.