Jubak's Journal
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Save your portfolio from Katrina and the Fed
The hurricane's huge economic impact will mean both price spikes and a new strategy from the Fed. Here's how to prepare your portfolio for both -- and find some profits.
By Jim Jubak
The bond market has decided that Hurricane Katrina will soon put an end to the Federal Reserve's interest-rate hikes.
Treasury bonds moved sharply higher in price on Wednesday, Sept. 1, tacking another 0.06% onto recent increases. The yield curve has inverted, with two-year Treasury notes yielding more than three-year notes, a sure sign that bond traders think that interest rates are headed down. The yield on a 10-year Treasury note is now 4%, just 0.3 percentage points higher than the yield on a two-year note.
And, finally, the fed funds futures market, where traders place their bets on the direction of interest rates, is now pricing in a 76% chance that the Federal Reserve will raise interest rates again when it meets on Sept. 20. But that's down from a 90% chance on Aug. 31 and the 100% odds reflected in prices during most of August. The odds for another rate increase in November have tumbled to 21% from 52%.
But hold on. The argument for a quick end to interest-rate hikes isn't nearly as overwhelming as it seems at the moment, while everyone is reeling from the daily reports of destruction coming in from the Gulf Coast.
A new sort of conundrum
I think the Federal Reserve is facing a huge dilemma right now. It's uncertain which way the interest-rate decisions will go at the September, November and December meetings of the Fed's Open Market Committee.
That uncertainty certainly makes the stock markets tough to read. But I think investors can put together a strategy, not just for coping with that uncertainty, but also for profiting from the Fed's Katrina dilemma. In this column I'll offer you 10 stock picks particularly well-suited to this uncertainty.
Related news and commentary on MSN Money
Here's the problem facing Alan Greenspan and Co. at the Federal Reserve. Even before Katrina, economists were worried that rising energy prices were finally starting to take a bite out of consumer spending, the engine for the economic growth in the recovery that started in 2001. Even if $40-a-barrel oil or $50-a-barrel oil wasn't enough to slow the economy, surely $60 or $70 oil would be, economists argued.
The devastation caused by Katrina has resulted in not just $70 oil, but $3- to $4-a-gallon gasoline. There's also the prospect of heating oil selling for $2.50 a gallon, and of natural gas at $14 per 1,000 cubic feet, up from $1.86 and $11.11 last winter, respectively. The argument for slower economic growth seems just about irrefutable.
The bond market has concluded that, if the economy is slowing, the Federal Reserve will stop raising short-term interest rates. Higher interest rates produce slower economic growth, economic theory says. Thats why interest rates are used as a weapon against inflation. But with the economy already slowing, the Fed can take its foot off the brakes.
A dangerously rapid slowdown, of course, would require a 180-degree change in policy. Then, we could expect the Federal Reserve to start cutting short-term interest rates again, to stimulate the economy.
Greenspan's hobgoblin: inflation
That reasoning would be absolutely convincing -- if the Federal Reserve just worried about economic growth. But economic growth isn't the Fed's only concern, or even its dominant one.
Greenspan's Fed is obsessed with keeping inflation under control and with preventing any return of inflationary expectations. Which makes Katrina a huge policy problem, since the devastation caused by the hurricane is wildly inflationary.
Higher energy prices are a huge part of this, of course. They ripple out across the economy, raising the prices for everything from air travel (the cost of jet fuel has soared) to anything shipped by truck (higher diesel prices).
But the effects aren't limited to energy. Katrina has disrupted the transportation and storage infrastructure of the Gulf Coast ports that handle a great proportion of U.S. imports and exports. So, for example, coffee prices have climbed better than 7% this week, with more than 25% of all U.S. coffee bean inventories stored in New Orleans.
No one knows how U.S. crops of corn, soybeans and wheat will get to market or where they'll be milled or stored, if the port of New Orleans stays out of commission for an extended period.
The disruption so far is driving down the price of grains, since middlemen aren't buying; they've got nowhere to store or ship these commodities. But it's likely that the long-term effect of the transportation shutdown in the region will be to drive up grain prices. Prices of other agricultural commodities already are rising: refined sugar, for example, costs 30% more than normal, reports the U.S. Department of Agriculture.
Even the rebuilding of New Orleans and the rest of the battered Gulf Coast will be inflationary. Many needed materials -- copper, cement and timber, for example -- were in short supply globally before Katrina. Reconstruction demand will push many commodity prices higher.
The correct conventional response to this kind of price inflation is, of course, to hike interest rates in order to bring down economic growth and dampen demand.
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