Reduce inflation risk in times of rising rates

What’s a strategy to protect against higher than expected inflation?

The market currently expects that the Fed can keep inflation around its target of 2.0% per year over the next decade. But the most recent Consumer Price Index at the end of January showed that inflation was running at 2.5% annually. So, if there is higher than expected inflation in the future, what’s a possible approach?

Treasury Inflation-Protected Securities – or TIPS – can help protect against inflation risk. TIPS outperform nominal bonds when realized inflation exceeds expectations. Currently, 10-year TIPS are priced so that they might outperform nominal bonds if the realized inflation over the next 10 years exceeds on average 2.0% per year*.

Investors who believe that inflation will be higher than expected for months to come should prefer TIPS over nominal bonds. But how likely is that to happen?

Political support in the US for fiscal stimulus, coupled with almost full employment, are likely to drive price growth. But, any interest rate hikes by the Fed will calm this inflation. So, keeping an eye on these two factors is key to assessing future inflation.

As we discuss elsewhere, inflation-linked securities compare favorably to other bonds with respect to risk and performance. The optimal ratio of nominal treasuries and TIPS, as well as portfolio duration, depend upon individual investor views and preferences.

Investors should be aware that past performance is not an indicator of future results.