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There is a plethora of ways to trade the inflation soon to be washing ashore in the USA and Canada. Unfortunately, many of the options are played out, such as gold. The best evidence of this is to ask a novice investor where the price of gold is going, or better yet, inquire with the next random person you run into on the street. I assure you the majority of the responses will be “up”, with many going on about the solid track record of commodities such as gold and their apparent “safeness”. I myself was subject to one of these pitches this past weekend.

For the record, this is the historical performance of gold over the past 36 years:

As you can see, the high in the early 80′s wasn’t revisited until over 25 years later. From 1975, the return on gold has been a pathetic 5.64%, slightly worse than the pathetic return of 11.86% on the S&P500 over the same time frame:

click to enlarge

On a comps basis, the best argument I read against a gold investment was in The Snowball: Warren Buffett and the Business of Life as well as a Buffett Interview with Ben Stein, in which he points out:

“Look,” he [Buffett] says, with his usual confident laugh. “You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”

To clarify, I’m not saying gold is never a good investment. If you had made a move when the hedge funds were back in '06 to '08, then you would’ve been killing it. What I am saying is at this moment in time, it’s not a purchase I would make.

But I am part of the crowd that believes inflation will be one of the consequences of the Fed’s many ill-advised policies, in particular QE2. The question is, how to profit off this inclination.

One unique way, and one that I have yet to read about, is to put a position on the yield curve, namely to short long term US Bonds. This can be done easily with an ETF such as the TBF.

Bond yields will rise when inflation rises, subsequently pushing bond prices down.

There are 3 dominant reasons I like this trade:

  1. Avoids the euphoria that currently surrounds equities and commodities - We are in the midst of what has aptly been titled the unshortable market, and one of the consequences of this broad rise in asset values is a greater challenge in finding good prices for great companies. Commodities have also enjoyed the run up, as discussed earlier. This trade avoids all the hoopla, while still exposing the investor to gains from inflationary monetary policy.
  2. QE2 comes to an end this summer - Without delving into a detailed discussion about what QE2 does and does not do, it does push up bond prices via Fed purchases of bonds to add liquidity to the system. With this programing coming to an end, it could act as a catalyst for bond prices to drop.
  3. Great risk/reward ratio - The above chart's price action demonstrates the low volatility of the position; in addition, there’s not a lot of room for bond yields to drop from already historic lows. Also, the long term nature of the bonds in this ETF ensures they will be impacted the most with a change in interest rates.

There are more complicated ways to put this position on, for instance, futures contracts targeting specific 5 year or 10 year notes. This ETF garners you similar results, is accessible to the retail investor, and a very liquid position, thus is a great route to go.

“I know of no society in human history that ever suffered because its people became too desirous of evidence in support of their core beliefs.” -Sam Harris

Source: TBF: Profiting From Inflation