Counter Moves to Inflation

My last article (see Low Interest Rates) concerned some of the potential problems associated with having interest so low for so long. I pointed out that “bubbles” might develop for some assets and that market corrections could result. You might wonder what actions we might be contemplating with client portfolios.

Let’s look at what is likely to happen when the Fed finally tightens up its monetary policy and allows interest rates to rise. Actually, “allows” is too strong a word. The Fed can only dictate ultra short term interest rates, such as those banks charge each other for overnight loans. If those investors participating in the bond market want to charge a higher interest rate because they consider things kind of risky, they will.

So let’s consider the scenario that the Fed determines that inflation is becoming a real threat and that they have had their foot on the accelerator long enough. If the Fed raises overnight bank rates, the bond investors will likely take their cue and start demanding higher interest rates. That will result in a drop in value of all the existing bonds at that moment (the “bond market”). Long term bonds will suffer the most, midterm not as much and short term bonds slightly but measurably. Again, how fast and how far interest rates rise cannot be controlled by the Fed. They surely would like the rates to rise mildly. It all depends on how spooky the investors are feeling.

But because rates have been artificially low for so long, the correction back to sensible rates dictated by normal supply and demand might be pretty sharp. So what would the investment advisors at HSC Wealth Advisors do as a counter? Moving client assets from long and midterm bonds to short term bonds is an obvious move. But there are also other types of inflation-resistant bond funds into which we can shift. Variable (“floating”) rate bond funds are available as are treasury inflation-protected securities (“TIPS”).

If the dollar is weakening due to inflation, other currencies are likely strengthening. In that case moving into foreign bonds might be good.

How about stocks? During inflationary times owning something (an “asset”) is usually preferable to having someone owe you dollars. Assets tend to retain their value as currencies bounce around. Stocks qualify as an asset. The owner of a stock owns a piece of that company. Of course some stocks will be better than others. Stocks of companies that produce assets are good. Think gold, precious metals and real estate. Stocks of companies that produce essential services, such as health and utilities should also hold value fairly well.

There should be lots of places to hide. But when times are tough and markets turbulent, we don’t hide! We examine portfolios and determine which positions are likely to fall and which will hold value or even rise. Then, after things have run a while, we sell some of what went up or held value to buy some of what went down.

Also, bear in mind that bond funds eventually tend to be self-correcting. Interest rates rise and bonds drop in value, as will the net asset values (think “share prices”) of the bond funds that hold them. But as the bond fund managers sell or allow to mature the old bonds with teeny interest rates, they will replace them with newer bonds with higher rates. Eventually investors realize they can have some great interest rates if they reinvest in bond funds. After receiving only half a percent on money market funds, 4% looks down right fabulous!

As usual, the key to coming through the storm of inflation is to be properly diversified.

We are.