If the Federal Reserve has its way, the U.S. will experience rapid inflation in the coming months/years. The Fed believes it’s easier to tame inflation rather than try and control the consequences of deflation. Historically low interest rates, quantitative easing 1 and 2, and a firm commitment to keep interest rates low for an extended period are all fuel for inflation, and a subsequent debasing of the U.S. dollar.
While a weak U.S. dollar helps manage America’s burgeoning trade deficit and benefits American exporters, it makes foreign goods more expensive. Although inflation is perceived as negative, investors should know that moderate inflation is actually healthy for the economy. The alternative is deflation – prices decline and consumers put off buying goods in anticipation of lower prices. Japan experienced a devastating bout of deflation in the 1990s.
So, what can you do to help protect your portfolio from a falling dollar and growing inflation? While there are many ways to hedge against a weakening dollar and inflation, here are three things you can do now to profit from the dollar’s decline.
1. Include commodities in your investment portfolio.
Most people think of commodities as just gold and oil; in fact, commodities encompass two broad categories: hard and soft. Hard commodities are those that are mined and include gold, silver, platinum, etc.; while soft commodities are those that are grown and include wheat, sugar, coffee, etc. Commodities are good inflation hedges because their prices do not move in tandem with the market (low correlation) and because commodities are consumed items; as the general cost of living increases – inflation, so does the price of soft commodities. Commodities are more volatile than traditional equities and have a higher expected return, but their low correlation with other assets make them an excellent diversifier in an overall portfolio.
2. Invest in foreign denominated fixed income (bonds).
Fixed income has long been used to minimize portfolio risk, especially when equities sharply decline in value. Investors who held a portion of their investments in U.S. Treasuries during the Great Recession saw their wealth decline less than those who were invested entirely in equities.
However, with U.S. Treasury yields at historical lows and the risk of inflation eroding fixed income, investors would be well served looking overseas, especially emerging markets, for fixed income opportunities. By investing in foreign denominated debt, investors can not only benefit from a higher coupon, but they can also benefit from a weakening U.S. dollar. If the U.S. dollar declines, the interest earned on a foreign bond is translated from the foreign currency back to the U.S. dollar at a more favorable rate.
3. Invest in Treasury Inflation Protection Securities (TIPS).
TIPS offer inflation protection because their interest payments are indexed to inflation, as measured by the Consumer Price Index, and pay more interest when inflation increases and less when there is deflation. TIPS can be purchased directly through Treasury Direct or through mutual funds and Exchange Traded Funds.
Although TIPS protect investors from inflation, investors should not allocate their entire fixed income portfolio to TIPS because if inflation is benign, TIPS will actually underperform traditional fixed income investments. This incongruent movement in price is actually what makes TIPS an appealing addition to any portfolio.
There are many more ways to protect against a falling US dollar such as buying foreign currency, trading currency futures contracts, and/or opening a foreign denominated bank account. However, while still effective, such tactics are much riskier and costly. If the Fed is successful, the above-mentioned strategies will help hedge a portfolio from inflation.