Inflation is an ever-encroaching threat.

Just this morning, the term “annus horribilis” (Latin for “a horrible year”) was dropped in a Yahoo! Morning Brief regarding 2022.

According to the article:

… inflationary pressures scorch U.S. consumers at a rate not seen in decades, souring the political fortunes of a U.S. president barely a year into his term. It’s also conspiring to make a tough job even tougher for the Federal Reserve chairman he’s recommending for a second term.

On Wednesday, data showed that December’s headline consumer inflation checked in at a sizzling 7% pace year-over-year, with core prices logging a 5.5% gain — the highest since 1991 and the hottest rise over 12 months since 1982.

Because of this inflation data horribilis, let’s revisit a Smart Money column we published in October 2021 – the points therein are even more applicable now, as we gear up to a potentially tumultuous 2022, in terms of inflation.

Inflation Also Rises

Technology by itself cannot prevent the Treasury from printing one inflationary dollar too many. Nor can technology overcome physical, supply-chain bottlenecks to transport a cargo ship full of semiconductors from Taiwan to an electric vehicle (EV) factory in Kentucky.

Current monetary trends, coupled with supply-chain constraints, wield a powerful inflationary force that technology might not be able to offset… at least not immediately.

Furthermore, financial markets are cyclical, no matter how much we might like them to be otherwise. Stock valuations cycle from very high valuations (like they are today) to lower valuations… and then return higher once again.

Interest rates do the same thing.

Once upon a time, interest rates were very, very high. Today, they are very, very low. A return to something in between the two seems like a reasonable bet, especially because so many inflation gauges are flashing red.

As we older folks well remember – and younger folks may have read in a musty textbook – soaring inflation rates often produce soaring interest rates.

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During the inflationary episode of the Vietnam War years, for example, the 10-year treasury yield doubled from 4% to 8%. Although that rate must have seemed quite high at the time, it would double again during the hyper-inflationary 1970s when it skyrocketed to nearly 16%.

But it’s been all downhill ever since. The generally tepid inflation readings of the past four decades have fostered a gradual drop in interest rates to near-zero. This delightful decades-long episode has emboldened an entire generation of investors to subsequently develop a near-zero fear of inflation.

To put it another way, four decades of low inflation readings have persuaded bond investors that a 1.52% yield on a 10-year treasury is a reasonable return.

In fact, bond investors seem quite content with that 1.52% yield, even though CPI inflation readings are hitting 30-year highs.

The Necessary Ammo

Now, inflation can be especially fatal for fixed-income investments like long-term bonds. As I pointed out in an October Smart Money column, the price of today’s 30-year Treasury bond could suffer a severe haircut if inflation continues inching higher.

For example, if rising inflation caused 30-year interest rates to rise from 2.0% to 3.0% over the next 12 months, the value of that bond would fall 20%.

If 30-year rates doubled from 2.0% to 4.0%, the price of the 30-year bond would tumble more than 35%.

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Inflation can also pull the rug out from under the stock market. Because of these risks, investors from earlier eras would buy precious metals to hedge against inflation.

In the modern era, gold may or may not provide its usual protection. The inflation-fearing Dorsey, for example, is not turning to gold for protection. Instead, he advocates an allocation to Bitcoin.

But rather than buying either gold or cryptos, some investors might prefer a more direct hedge against inflation… like selling short long-term bonds.

Selling short means betting against a stock or some other financial asset. Unlike typical trades that benefit from a rising price, a short sale benefits from a falling price.

Therefore, an investor who sold short the 30-year Treasury bond at today’s prices would make money if a rising inflation rate caused bond prices to fall.

For most investors, the process of short selling seems difficult and confusing. Conveniently, however, several “short-focused” ETFs do the heavy lifting themselves and provide an easy way for ordinary folks to “sell short” different sectors of the bond market.

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One of these ETFs is the ProShares Short 20+ Year Treasury ETF (NYSEARCA:TBF). It bets against long-dated treasury bonds. The guts of its portfolio are interest-rate swaps that increase in price as long-term interest rates rise. As such, this ETF offers a direct and “clean” hedge against inflation.

This ETF has been a big loser for most of its 12-year existence. But that’s because interest rates trended lower during that period.

If interest rates were to begin heading significantly higher, instead of lower, this ETF would finally reward its shareholders.

Regards,

Eric Fry

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On the date of publication, Eric Fry did not have (either directly or indirectly) any positions in the securities mentioned in this article.

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