Daily Gains Letter

Concerned About Inflation? Consider These Two Hedges Against It

By for Daily Gains Letter |

Two Hedges AgainstThe Federal Reserve expects inflation to stay below two percent until the year 2015. (Source: “Economic Projections of Federal Reserve Board Members and Federal Reserve Banks Presidents, September 2012,” Board of Governors of the Federal Reserve System, September 13, 2012.) The goal of the Federal Reserve is to keep the inflation rate between one and three percent so there are no price swings and Americans don’t suffer.

In November 2012, the Bureau of Labor Statistics affirmed that our central bank is meeting its inflation targets—the consumer price index (CPI) decreased 0.3% in November, but inflation is on track for a yearly increase of 1.6%. (Source: Bureau of Labor Statistics, December 31, 2012.)

With that said, the Federal Reserve has been imposing monetary policies, which are troublesome at the very least—keeping interest rates artificially low and printing U.S. dollars at a record pace.

To give you some perspective, in the beginning of 2010, the total amount of notes and coins in circulation in the U.S. economy was a little over $927 billion. Fast-forward to today, and we have total notes and coins in circulation of $1.2 trillion—an increase of more than 25.0% in two years in notes and coins alone! (Source: “Currency in Circulation,” Board of Governors of the Federal Reserve System, December 26, 2012.)

From all of this, it doesn’t take a rocket scientist to know what’s next to come: a period of high inflation. Why? Because the Federal Reserve is printing trillions of dollars, which will eventually cause the dollar’s value to decline. In result, goods will become expensive.

How does inflation affect your portfolio? If you are invested in stocks, you shouldn’t worry as much. If there is increased inflation, the hope is that each company’s revenues and profits will adjust accordingly—they will increase prices. But for the fixed-income portfolios, inflation can take a significant cut.

Consider this: if you only own bonds in your portfolio, and they earn you five percent a year, while inflation is running at two percent, what is your actual rate of return in this case? Your real rate of return would only be three percent.

If investors are worried about inflation increasing in the future, there are ways they can protect their portfolios. They can either buy gold or invest in securities that go up in value as inflation increases.

Gold

Gold has been known as one of the best inflation hedges. What holds true about gold is that it doesn’t decline in value like the paper-based currency. As the value of a currency goes down and inflation increases, gold actually rises in value.

As the Federal Reserve has printed trillions of dollars, gold has increased in value. With inflation becoming a concern in the future, gold will continue to store value and could be used as a hedge against it. Below is the chart of gold spot prices for the last three years, showing that it has significantly increased in value.

Gold Spot Price Chart

Chart courtesy of www.StockCharts.com

ProShares UltraShort 7-10 Year Treasury

Inflation usually starts to take a grip in the low interest rate period, which we are in now. The Federal Reserve uses interest rates to control inflation. Once inflation increases, the Federal Reserve will be forced to increase interest rates. As a result, bond prices will fall.

In essence, ProShares UltraShort 7-10-Year Treasury (NYSEArca/PST) is an exchange-traded fund (ETF) that shorts bonds. Hence, the more bonds fall in price, the higher the price for PST.

ProShares UltraShort BarClays Chart

Chart courtesy of www.StockCharts.com

This ETF has been trading at its record-low price, but as inflation picks up and interest rates rise, it could see a significant price swing to the upside.

Most often, investors might forget the impact of inflation on their portfolio. It reduces the rate of return and may become a problem when it comes to retirement planning. There are ways investors can protect their portfolio from inflation—and investors should always consider the effects of inflation on their portfolios.

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