There are signs that the risk of inflation may be underestimated.
After several years of low inflation following the Financial Crisis of 2007-2008, expectations about US inflation are changing. The Fed’s Federal Open Market Committee (FOMC) decision in December and the election of Donald Trump have triggered expectations that US inflation may be trending upward in coming years.
So, what can you do to protect your portfolio against a rise in inflation?
Nominal bonds have no structurally embedded protection against inflation shocks, but Treasury Inflation-Protected Securities, or TIPS, are indexed to inflation so that purchasing power is preserved. The current market for TIPS is valued at USD1.1 trillion (Barclays US TIPS Index) having grown substantially since inception in 1997.
The break-even inflation (BEI) rate captures the yield spread between nominal and inflation-linked bonds, like TIPS. If inflation averages more than the BEI rate indicates, the inflation-linked bond will outperform the fixed-rate bond. If inflation averages below the BEI rate, the fixed-rate bond will outperform the inflation-linked bond. Investors who think future inflation will be higher than indicated by the BEI rate may consider reallocating some of their nominal position into TIPS.
Portfolio diversification with TIPS is a promising strategy in a scenario of sharply rising inflation. When we looked at the data, shorter-term TIPS were preferable to longer-term TIPS for investors who want their portfolio to follow realized inflation over short horizons.
Investors should be aware that past performance is not an indicator of future results.