Hedging Against Inflation Risk and Speculating About the Fed


Over the last few years, one of the most consistent questions we have received from both prospects and clients is, “How can I protect myself from high inflation?” Please note that since 1991, there has only been one calendar year (2007) where the rate of inflation (as measured by the change in the Consumer Price Index) exceeded 4%. Thus, high inflation sometimes seems like the bogeyman of investing—always expected yet rarely materializing. Please do not misunderstand us, as inflation is a very real risk that we discussed in this article on the risks facing retirees. In William Bernstein’s latest book, Deep Risk: How History Informs Portfolio Design, he counts hyperinflation as one of “the Four Horsemen of Financial Disaster”. The other three are a deflationary depression, government confiscation of assets, and devastation due to international conflict or civil war. In this article, we will review some of the options for addressing the risk of higher-than-expected inflation (which need not reach the severity of hyperinflation), utilizing recent research1 from James L. Davis and Wes Crill of Dimensional Fund Advisors (DFA).

Davis and Crill examined the 53-year period from 1/1/1960 to 12/31/2012. They sorted these years into two nearly equal size buckets representing low inflation (26 years) and high inflation (27 years). They compared the returns of the following five asset classes: U.S. Treasury Bills, U.S. Treasury Bonds (maturities from five to twenty years), U.S. stocks, International bonds (not currency hedged), and international stocks. Most of their data came from the Dimson-Marsh-Staunton Global Returns Database.

As shown in the bar chart below, international equities obtained the highest real returns during the high inflation years while domestic equities dominated during low inflation years. One contributing factor to international equities and bonds beating their U.S. counterparts during high inflation years is that high inflation is often accompanied by a weakening of the U.S. dollar, which is good for investors in foreign securities that are not currency-hedged. However, as the authors point out, high inflation can also be a global phenomenon, in which case foreign securities would not provide a place to hide. One other point worth noting is that the only one of the five asset classes that did not have lower real returns during periods of high inflation was Treasury Bills. However, since the bond market sets interest rates to include a component for expected inflation, it does not surprise us that extremely short-term bonds would capture inflation but not much beyond it. For about the past five years, Treasury Bills have returned close to zero, implying a negative real return. As expected, there is a direct relationship between the risk (standard deviation) and the excess return over inflation among the asset classes.

While it would have been interesting to include Treasury Inflation Protected Securities (TIPS) in this analysis, their data only goes back to 1997, and it does not include a period of high inflation. TIPS do provide a hedge against unexpected inflation, but it comes at a cost of giving up the risk premium for bearing the risk of unexpected inflation.

Like Davis and Crill, Bernstein also suggests global equities as a good long-term hedge against inflation. Bernstein cites returns data from Weimar Germany (the quintessential example of hyperinflation) showing that German equity investors received a positive real return that doubled their purchasing power from 1920 to 1924. Of course, they paid for it by holding on during a period when it truly appeared that the whole German economic system was in grave peril, and during the middle of that time period, their investment was down to a third of its original value. To us, this represents a perfect example of Dr. Bernstein’s observation that the currency of risk is stomach acid and sleepless nights.

In closing, we will consider the Quantitative Easing (QE) program of the Federal Reserve in which it is buying long-term US Treasury Bonds and government-backed mortgage securities on the open market at rate of about $85 billion per month, and the “funds” used for these purchases are computer-generated short-term reserves. This can be thought of as the digital age equivalent of printing money. Last year, the primary concern we heard from investors was whether the continuation of this program would bring about high inflation. Clearly, that has not yet happened. Today, the concern is what will happen when the Fed winds down the QE program. The metaphor often invoked is that the market is now a junkie that cannot live without its regular injection of funds from the Fed that serve to artificially inflate asset prices. Of course, nobody knows with any certainty what will happen when the Fed tapers down QE (or publicizes its plans for doing so), but the market is fully aware that it cannot continue forever, and this fact is reflected in today’s prices. An academic whom we greatly respect, 2013 Nobel Laureate Eugene Fama, also known as the father of modern finance, has opined on several occasions that the influence of the Fed on interest rates has been overstated. In a recent interview with InvestmentNews magazine, Fama had this to say:

“I don’t think the Federal Reserve has any role in how high rates are right now. I don’t understand why everyone is paying attention to this tapering. The Fed is using one kind of bond to buy another kind of bond. What’s the big deal, and why is anyone taking the Fed seriously?”

Fama’s essential point is that if the Fed truly determined interest rates, then not only should long-term interest rates have decreased, but short-term rates should have increased, yet they did not. Fama’s conclusion from his recent working paper2 on the Fed is that its influence on interest rates is indeterminate at best. Our conclusion from all of this is that most investors will not profit themselves by joining the legions of Fed watchers, and investors who base their asset allocations on speculation about what the Fed will or will not do are setting themselves up for disappointment.

If you would like to learn more about the benefits of a globally diversified portfolio of passively managed funds, please give us a call at 888-643-3133.

1Davis, James L. and Crill, Wes, “U.S. Inflation and the Returns in Global Stock and Bond Markets”, Dimensional Research, November 2013.

2Fama, Eugene F., Does the Fed Control Interest Rates? (June 29, 2013). The Review of Asset Pricing Studies, Forthcoming; Chicago Booth Research Paper No. 12-23; Fama-Miller Working Paper. Available at SSRN: