What is the Federal Reserve doing about inflation, and how might their actions affect us? The Fed’s dual mandate is to drive towards maximum employment and stable prices (i.e., managed inflation). Their definition of “low and stable” inflation is 2% per year. When the Fed increases the Federal Funds Rate (that’s the interest rate the Fed charges on reserve balances), we expect to see bank interest rates rise, along with rates on commercial paper and US Treasury Bills.
The Fed made half-point interest rate increase in May, probably will do so again in June, and possibly two more times in 2022. We could end 2022 with Fed rates at 1.5% to 2.25%, depending on how the Fed balances rates, inflation, and recession risk.
What’s this all mean to an investor? We’ve previously noted that the last time there was a major inflation issue in the US, S&P 500 volatility was high. Now let’s consider bonds. Many investors include bond holdings in their portfolios to reduce overall volatility. Yet, when yields rise, bond prices fall. So an investor who smoothed out her portfolio with $1M of bonds might find the valuation of those bonds to be much lower as rates increase.
Think of it this way: when rates go up, new bond offerings have to provide higher returns. Consequently, older bonds, issued at a lower interest rate, are less appealing to the market. The net value declines, and the rates you’re getting are lower than market, and probably lower than inflation. That implies you’re actually losing money in your bonds, as you have to subtract the inflation rate from your nominal interest rate.
Except for TIPS: Treasury inflation protected securities. These bonds are indexed to inflation, so their returns increase when inflation does.Unfortunately, TIPS’ protective properties are priced-in, so they typically outperform Treasury Bonds only when the CPI is higher than the market expected. Also, often actual consumer experienced inflation exceeds the stated CPI values, preventing full inflation compensation. Finally, TIPS are volatile: because upside inflation adjustments can be taken away through a “deflation floor,” TIPS can take a hard shot - as they did in 2008 and March 2020.
So what might an investor do to balance portfolio risk-return in an inflationary period? Stocks might keep pace, if you can withstand the roller coaster of volatility. Bonds might be another way of locking-in after inflation loses. What other alternatives might you consider? Stay tuned, as we’ll try to answer this in our next blog post.
Comments