Robert Zingale's  Instablog

With the dollar hitting a yearly low and the Federal Funds interest rate near zero percent, I think many people should be concerned about when inflation will creep back into the economy.  Looking at the following two charts from the St. Louis Fed, one can see why inflation has been held in check for the past year.  The money multiplier has fallen below one and has not moved much since the beginning of this financial crisis.  At the same time, the monetary base has exploded as the Fed has injected lots of new money into the banking system through their open market operations.  I do not think that the Federal Reserve will be able to accurately time the winding down of the monetary base to ward off future inflation, because there has not been much precedence of this before.  Inflation and high inflation have been in existence since fiat monetary systems have been created.

You can protect yourself from inflation by buying Treasury Inflation-Protected Securities (TIPS).  TIPS distribute coupons semi-annually like most other bonds.  The difference is that TIPS pay a fixed percentage of the underlying principal.  The principal is adjusted semi-annually by the percentage amount that the CPI has changed.  Right now, the difference between a 10-year Treasury bond (3.46%) and 10-year TIPS (1.63%) is 1.83%.  This means that investors roughly think that inflation will only average 1.83% over the next 10 years.  The median rate of inflation has been around 2.5% over the past twenty years.  The only drawback with TIPS is that the principal accrued through the inflation adjustments is not paid out annually, but these earnings are taxed by the government.  Therefore, you are paying taxes on earnings that you have not yet received.  This makes TIPS an extremely unattractive investment for investors in taxable accounts.  This also means that the previous statement about inflation expectations is not completely accurate, because the differences in taxation do not make these securities completely comparable.  However, if you are considering adding these to your retirement account, I would support this decision. 

Besides being more attractive than other Treasury securities, TIPS can be a great compliment to a highly concentrated equity portfolio.  Buying stocks to protect yourself against rising inflation may seem like a great idea at first glance, but history has told us that this is not actually the case.  Looking at the line graph below, one can see that periods of extremely high inflation occurred while the stock market performed poorly.  The most recent instance of this occurrence happened last year.  Last August, high oil and commodities prices seemed to have everyone worried that inflation would spiral out of control.  At the same time, the stock market was sluggish and was actually preparing itself for one of the worst declines in recent history.  Holding TIPS from August 2007 to August 2008 would have allowed you to maintain some of your real wealth while reducing the riskiness of your portfolio. 

Percentage Change from Previous Year

        Since 2006, ProShares has offered Ultra ETFs that have exposure to twice the daily exposure to certain underlying indexes.  These ETFs can either be long or short the daily index.  These ETFs are able to track the daily inverse by using financial instruments that allow them to use leverage.

Right now it appears that oil is trading above its “full carry” value.  A “carry trade” on oil involves selling a longer dated futures contract and buying the commodity at spot price to store it until delivery.  The “full carry” price should not exceed the cost of storing the commodity; otherwise it presents an arbitrage opportunity.  According to a recent article in Reuters “Oil contango may linger, inflate stockpiles,” analysts estimate that average onshore storage costs about 70 cents per barrel.  Below is a chart for NYMEX Crude Oil (Light) quoted on the Globex.

While the basic materials equity index is up nearly 24% over the past month, iPath Dow Jones AIG Total Return Commodity Index ETN (DJP) is up only 8%.  If you blinked and missed this historical run up in equities, you can still gain some exposure to a possible recovery in the global economy.  Commodity prices reflect relationships between short-term supply and demand for goods.  Commodity price increases will occur in greater effect once economic activity begins to pick up.  Unlike commodities, investing in individual commodity producers requires an investor to be exposed to a great deal of unsystematic risk.  Commodity producers have recently priced in much of the future prospects of economic growth, whereas commodities have not reflected these prospects to the same extent.