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Protecting Against Inflation While the Fed Prints Away

I recently heard a top economist from Goldman Sachs suggest that the Fed has not done nearly enough in the current crisis and that the true fight is still the fight against deflation.  That can only mean one thing: print more money.  As the Fed looks at further ways to pump more liquidity into the market, I think it is important to find ways to protect wealth against an almost certain future of higher interest rates, a falling dollar, and some rampant inflation.

As Obama would say, “Look, Listen, Let me be clear” – I do not think inflation is coming soon.  I do believe that the consumer has to step back into the mix in order for prices to be driven higher.  That being said, if you pump enough money into the economy (and we have already pumped a lot!) then we should expect that banks will eventually start to feel comfortable enough to start lending to American consumers again.  That could happen as early as mid 2010 which implies that those with access to credit might start spending again because the dollars that continue to be printed start to flow freely to everyone.  I have also heard many suggest that the Fed will most likely keep the discount rate low through 2010 and will only start to shut off the spigot when they truly believe there is inflation.  The problem is that inflation often comes on like a burning wildfire and it takes a bit of time to stamp it out.  In addition, the programs that were put in place will be difficult to unwind quickly(reverse repo anyone?) – especially those that involved the purchase of securities from the market place.  The Fed will have a difficult time selling those back to the market at a loss which would effectively tax the US Citizen.  Good luck explaining that to congress Chairman Bernanke.

With all of this as the backdrop, what do you do? Inflation is only good for companies that are able to pass on the higher costs to the consumer or benefit from higher priced commodities.  Over time equities often are a decent hedge against inflation, but in the short run they will be impacted strongly from rising interest rates and their inability to pass costs on to an America with 17% real unemployment.  Commodities generally provide a good hedge against inflation, but individual commodities can see strong technical and supply/demand imbalances which overpower inflationary forces (take a look at natural gas).  Diversified commodity plays can be found by investing in the ETF’s DBC, DJP, and GSG.

Over the long haul, real estate in the form of REIT’s generally provides a decent inflation hedge but over the short-term the hedging quality is strongly counteracted by supply/demand imbalances.  If there is a glut of recently built office spaces and high vacancy rates then the structural imbalances in the market will make returns suffer regardless of the level of inflation.  Only use REIT’s as an inflation hedge if you believe that we have hit a balance between supply and demand in the commercial real estate market.  Considering that commercial real estate is still plummeting in value and office vacancy trends are still negative, I would hold off on the REIT play as a pure inflation hedge.

Now that we have addressed commodities, REIT’s and equities the other large lingering asset class is fixed-income.  The key problem with most of fixed income is just that, that it’s fixed.  A coupon payment of $10,000 is not nearly as attractive after a few years of rising costs via double digit inflation levels.  Treasury Inflation Protected Securities (TIPS) act as a hedge against inflation, but their coupons are usually quite low due to their minimal credit risk.  A portfolio of corporate bonds has attractive yields, but can be utterly exposed to rising inflation rates.  All else equal, longer bonds will be hit harder than short-term bonds so high inflation environments are best combated with short maturity fixed income securities.  The alternative is to be long corporate bonds and hedge rising rate and inflation risk by shorting treasury bond futures or buying put contracts on treasuries by buying put contracts on the long term treasury ETF with the ticker TLT.

By hedging with treasury futures or buying put options on treasuries you do two things:

  1. You immunize your corporate bond interest rate exposure which hedges against inflation and rising rates
  2. You make a bet that the US Government’s cost of borrowing will go up in the future as we have an ever increasing amount of sovereign debt

Two things that seem to make a lot of sense.

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