Returns Correlated To Inflation
When we think a bit more precisely about what we can add to a portfolio for a limited period of time to hedge against inflation when we are particularly concerned, we’re saying we want an asset that will experience a large positive return when inflation increases. That’s another way of saying we want to own assets with returns that have a high correlation to inflation.
In a related sense, we might be interested in highlighting those assets that might do particularly poorly during a sustained inflationary period.
So, how does inflation affect the markets? The primary effect on assets is that increases in expected inflation and its volatility—that is, how unpredictable inflation is—both tend to push real rates up. Since nominal interest rates are real rates plus expected inflation, an uncertainty causing spike in inflation is a double whammy to assets.
The following chart shows the average quarterly correlation to inflation of several assets that are either commonly in portfolios or often touted as inflation hedges. Bonds fare the worst, while T-bills do the best. Let's discuss each asset and appropriate vehicles in turn.
Inflation is rightly considered to be the scourge of bonds, and the longer the maturity of the bond, the worse it is.
Long-term ETF bonds reflected in such funds as the iShares 20+ Year Treasury Bond ETF (TLT | A-85) or the iShares 7-10 Year Treasury Bond ETF (IEF | A-58) have a negative correlation to monthly inflation. In other words, you can expect to lose capital because of price declines and have the real value of your portfolio be eroded by inflation too.
In the event of higher inflation, a Treasury bond portfolio is about the worst thing you could have, and you should therefore consider reducing the duration of your portfolio. Daring investors might want to investigate inverse Treasury funds such as the Direxion Daily 20 Year Plus Treasury Bear 3x ETF (TMV). But it is difficult to be profitable when you’re short the bond market and, moreover, short positions as well as exposure with leveraged products require meticulous risk control.