Bonds, on the other hand, weren’t so lucky. They returned a negative 0.8% a year after inflation during the period. That isn’t surprising, either. Higher inflation should result in higher interest rates, both because lenders want to be repaid in real dollars and because central bankers are likely to raise rates to tame inflation, as Fed Chair Paul Volcker did in the early 1980s. In fact, while the correlation between inflation and 10-year Treasury yields has generally been weak since 1871 (0.26), it strengthened during the period from 1970 to 1982 (0.52) as interest rates followed inflation higher. (A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.)
And when interest rates go up, bond prices go down—but not all bonds, and not all equally. In general, bonds with longer maturities are more vulnerable to rising rates than those with shorter maturities, and that made all the difference. While an investment in long-term government bonds eroded in value from 1970 to 1982, five-year Treasuries returned 0.8% a year after inflation and one-month Treasuries perfectly tracked the inflation rate.
The takeaway from all this is that investors who are worried about inflation needn’t overhaul their portfolio. A simple mix of stocks and short to medium-term bonds is probably a better bet than investments widely peddled as inflation protection, such as gold, cryptocurrency, real estate or even inflation-protected Treasuries. A smattering of those investments isn’t likely to make much difference and serious investors would not put all their eggs in one of those baskets.
Those tempted to hoard gold bars until the threat passes should think twice. As probable as inflation may seem, it’s impossible to know when it will take hold, if ever. Inflation bugs have been carping for years that the fiscal and monetary stimulus unleashed after the 2008 financial crisis would stoke inflation, but it hasn’t happened despite the Fed’s repeated attempts to lift prices. Japan’s central bankers have been at it for nearly three decades, mostly without success.
It’s worth noting that the bond market isn’t worried about inflation, either. The breakeven rate, or the difference between the yield on nominal and inflation-protected 10-year Treasuries, a widely followed gauge of expected inflation, is just 1.4%. While it has risen since the coronavirus-induced financial panic receded in late March, it has also trended down since 2018 and remains stubbornly below the Fed’s inflation target of 2%. People love to think that they know more than the market, and they’re almost always wrong.
Investors are free to worry about inflation, of course. But most are likely to find that the best defense is already nestled in their portfolios.
This article was provided by Bloomberg News.