How To Beat The Fed At Its Own Game

By Daniel Kadlec

Maybe now we'll take Alan Greenspan seriously. A perpetual pessimist, the Fed chief has for the past year been nipping at inflation he sees hidden in the economy's weedlike growth. Last week, though, he got serious, boosting interest rates a convincing half a percentage point, to 6.5% on the benchmark short-term federal funds target rate, and making it clear that more increases are to come.

If you're house hunting, carrying a lot of debt or underwater with recent stock-market losses, this is a painful shot of economic medicine. It means mortgage rates will be going higher, as will the rate on virtually all other new loans. Credit-card rates, already steep, will increase, and the floating-rate debt you already have will become more costly. These conditions are telling you to pay for more things with cash, pay down debt and--this really hurts--lower your expectations for investment returns.

Greenspan's goal is to slow the economy just enough to quell inflationary pressures resulting from torrid growth and rising wages. He pulled it off with a series of rate increases in 1994. Still, economic engineering is inexact. The risk is that he'll overstep, slowing things to the point where consumers disappear, corporate profits tumble and layoffs mount. It's a legitimate fear voiced by a growing number of Greenspan detractors.

But if you accept that millions of people betting with their wallets collectively know best, there is little cause for panic. The markets are signaling thumbs up. Stocks took the news of higher rates in stride, rallying in the days prior to the rate boost and again on Tuesday, when the announcement came. Bank and other financial stocks--highly vulnerable to rising rates--were among the strongest, suggesting that investors may sense an end to the Fed's campaign.

Indeed, the bond market appears to be pricing in a quarter-point increase in June and possibly another late in the summer, but nothing beyond. That's not an all-clear sign, but the bond market's configuration today offers a classic reading for the slower growth Greenspan wants dead ahead. Normally, longer-term maturities on interest-paying investments like the 10-year Treasury note carry the highest yields because an investor assumes more risk over that extended period before getting back his principal. Now, however, the yield on 10-year Treasuries is around 6.5%; on two-year Treasuries, about 6.8%. When the "yield curve" inverts like this, bond traders are betting that short-term rates are high enough to cool the economy and keep inflation at bay. We're already seeing signs of slowing in retail sales and housing.

With all that in mind, how should you position your financial affairs for the next 12 months? As always, that depends largely on personal factors, including your income, age and tolerance for risk. But here are some guidelines:

--Mortgages. This is no time to lock in a 30-year fixed rate. "That would be insane," says Jeffrey Cohen of financial planners Siller & Cohen in Tarrytown, N.Y. Mortgage rates are already at five-year highs. There is a good chance that they're peaking. If the Fed's pre-emptive strikes are working, the rates should start to come down in the next year or two.

Cohen advises looking into a hybrid mortgage like a 5/25. You get the near-term protection of a fixed rate for five years, and then the rate floats to market levels. Odds are that rates will move down within five years and you'll be able to refinance. Avoid one-year adjustables unless you need the teaser rate and expect a plumper income within 12 months. It's unlikely that market rates will be significantly lower when the teaser rate expires just a year from now.

--Other debt. Rethink all the ways you are using leverage, such as carrying credit-card debt while owning stocks or borrowing against your home to buy a boat. As rates go up, the investment or enjoyment return on whatever you purchased must go up commensurately for the arrangement to make sense. Dump as much debt as you can. If the economy tanks and your income goes down, high-rate credit-card debt, especially, can ruin you. Pay off high-rate non-tax-deductible debts first. If possible, consolidate your nondeductible debts--including auto loans--into a deductible home-equity loan. Target variable-rate loans first.

--Stocks. Get real about how fast they will rise. As rates go up, investors are more inclined to own interest-paying investments. And higher rates put the squeeze on corporate profits, making stocks less desirable. The recent string of 20% gains a year for the average stock is probably over. Look for something closer to the historical 11% and possibly even less than that to make up for five off-the-chart years from 1994 to '99.

That's why you might consider selling some stocks to pay down debt. The stocks you keep should be diversified but tilted away from high-risk tech issues and toward reliable blue chips that earn good money in any economy. Food and drug stocks are examples. Beaten down cyclical stocks like airlines and advertising could run while rates are rising--so long as we don't fall into recession. Financial stocks will perk up as the rate increases come to an end.

--Bonds. Bond prices fall as long-term rates rise, and the moves are sharpest as you move out on the yield spectrum. Stay away from 30-year bonds until it's clear that long-term rates have peaked. A better bet--one that will lend your portfolio stability, win big if long-term rates fall soon and yet won't hurt much if rates tick higher--is bonds with maturities of three to seven years. Consider an intermediate-term bond fund. "They give you 95% of the yield of the long bond [30-year] with only two-thirds of the risk," says Tom Orechhio of financial planners Greenbaum & Orechhio in Oradell, N.J.

--Auto leasing. A leasing company may get a better rate than you can and pass it through. A lease may make sense if you are on a tight budget, because leasing companies can finagle the residual value and term length to reach the same payment you might have got last year. Careful: such a lease may cost more over the length of the lease. This is the brave new world of higher interest rates. It doesn't mean the good times are over, but the party is certainly winding down.