Can We Really Hedge Inflation?

By:

Chief Strategist at Interactive Brokers

Inflation is certainly a topic on everyone’s mind lately, and for good reason.  US consumers haven’t seen prices rise this fast since the early 1980’s, which was before most current investors were active in the market.  At that time, Paul Volcker’s Federal Reserve was taking active measures to calm inflationary pressures; at present, the Powell-led Fed is still talking about raising rates and reducing its bond purchases, but rate hikes are only theoretical and the taper is proceeding more slowly than they would have us believe.[i]

For many of us, oil prices are the clearest harbinger of inflation.  We see gas prices posted whenever we drive, and most of us still need to fill our cars regularly.  A chart like this would certainly fit with the inflationary theme:

1-Year Graph, Front Month NYMEX Crude Oil Futures

1-Year Graph, Front Month NYMEX Crude Oil Futures

Source: Interactive Brokers

To be fair, oil is a volatile commodity, and is far less critical to the economy than it was in Mr. Volcker’s day, but it remains a key input to a wide range of unfinished goods and services.  A rise like this definitely stings.

The inflationary theme is certainly picked up by other measures.  The graph below shows two of them, the Consumer Price Index (CPI) and the Commodity Research Bureau BLS Spot Index (CRB).  The CPI is updated monthly and contains a broad range of inputs, while CRB is continually calculated by using popularly traded commodities, but we see they generally tracked each other well over the past two years:

2-Year Chart, CRB Index (white, left scale) vs. CPI (blue, right scale)

2-Year Chart, CRB Index (white, left scale) vs. CPI (blue, right scale)

Source: Bloomberg

The problem is that neither index displayed above is easily hedged.  There are no futures on either index, and attempts at ETFs on the CRB have generally failed.  One could buy TIPs, Treasury Inflation Protected securities, which are liquid and have active ETFs, but many critics complain that their prices are distorted by the Fed’s bond buying.[ii] 

The classic inflation hedge has historically been gold, but it has fallen short of that goal recently, as the graph below shows:

1-Year Graph, Spot Gold in US Dollars (USGOLD)

1-Year Graph, Spot Gold in US Dollars (USGOLD)

Source: Bloomberg

Let’s be blunt.  If you bought gold as an inflation hedge, it hasn’t worked.  This is something we addressed last spring, and the relationship hasn’t improved much since then.  Gold often acts more like an “anti-dollar” rather than an inflation hedge, and this is one of those periods. 

Undoubtedly some of you are thinking “what about cryptocurrencies?”  Um, no.  They rose early last year when inflation began to rise, but that was more about their adoption as a speculative investment than as a hedge.  Since then, they have been of little value as a hedge, as shown below:

2-Year Chart, CRB Index (white, far left scale) vs. CPI (blue, right scale), Bitcoin (red, near left scale) and Spot Gold (purple, far right scale)

2-Year Chart, CRB Index (white, far left scale) vs. CPI (blue, right scale), Bitcoin (red, near left scale) and Spot Gold (purple, far right scale)

Sorry, but there are no easy answers when it comes to hedging inflation.  Furthermore, the more difficult answers generally involve items that are less liquid, longer-term investments.  For now the best answer is to manage your risk and keep your exposures in check.

[i] The holdings of securities on the Fed’s balance sheet was $8,391,301 million as of February 2ndOn January 6th, that figure was $8,279,124 million.  That shows a rise of over $112 billion, which is well more than what many would expect based on the announced rate of tapering. 

[ii] There are Series I Savings Bonds, issued by the US Treasury that are inflation-linked and currently yielding 7.12%.  But there are strict limitations on purchase size and penalties for early redemption.

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