Inflation — the arch nemesis not just of the fixed-income market, but potentially of a nation’s entire economy (see Zimbabwe).  There has been increased talk of potential inflation in the U.S. as the federal government debt zooms past $11 trillion with ubiquitous predictions of multi-trillion dollar deficits exacerbating the problem.

Obviously, a rising federal government debt has negative implications for future inflation.  However, this is far from the only debt threatening to storm the gates.  State and local governments are facing some of their most trying times ever in balancing their budgets — taxes are being raised and services are being cut — yet bankruptcy is a looming possibility for more and more municipalities.  Add to this the frightening situation over unfunded pension liabilities and you have a recipe for disaster.

Already, fears of governments not being able to fund their growing liabilities are spooking investors.  Just last week, Great Britain was unable to sell 1.75 billion pounds of 40-year gilts (British Treasury bonds).  The hegemony of the U.S. dollar has made it highly doubtful that the U.S. would default on its debt, though by running the printing presses overtime, the government may simply “monetize” its debt, rendering the value of the currency in which the debt is paid all but useless.

Recently, both Russia and China have made noises regarding the risks (to all countries without the initials USA) of maintaining the U.S. dollar’s place at the top of the global currency pecking order.  Last Thursday, China’s mere suggestion of introducing a global reserve currency caused a vicious selloff in the dollar on world currency markets.  Later, a United Nations panel ran with the same idea.  Clearly, a pattern of nervousness is growing in the guts of some of our country’s biggest debtholders (China currently holds a $700 billion-plus IOU with Uncle Sam’s autograph at the bottom of it).

Inflation hasn’t been a huge problem in the U.S. in a generation.  But the days of 18% mortgage rates and WIN (Whip Inflation Now) buttons could be just around the corner.  When inflation strikes, the cost of protection will be prohibitive.  What follows can be thought of as the personification of The Lamb’s Rule #7 — “If you’re gonna panic, make sure you’re the first.”

There are several ways to protect oneself from the dangers of inflation.  While some are simpler than others, each carries varying degrees of difficulty and liquidity built into it.

*TIPS — An acronym for Treasury Inflation-Protected Securities, these are U.S. Treasury notes that pay a fixed coupon plus the rate of inflation.  For example, the current 10YR TIP carries a real yield of approximately 1.25%.  That means that, if bought and held to maturity, an investor would earn 1.25% plus the rate of inflation as measured by the U.S. Consumer Price Index (CPI).  TIPS can be bought from myriad securities dealers and from Treasury Direct. 

However, while the coupon on TIPS moves in step with inflation (via adjustments to the bond’s principal), TIPS do not protect investors from increases in market interest rates.  In other words, as real yields rise, the value of TIPS will fall, often precipitously given their very high durations.  Only by concurrently shorting nominal Treasury securities against a long position in TIPS (somewhat difficult from a practical standpoint) can an investor protect himself against an increase in real rates.  As a final caveat, the CPI figure’s components are determined and calculated by the very entity paying the coupon (the U.S. government), creating somewhat of a conflict of interest.

*Rate ETFs — Exchange-traded funds (ETFs) have been around for several years.  They are relatively liquid and trade very much like stocks.  They were created to enable investors to participate in strategies or to purchase combinations of stocks (similar to mutual funds) in which they would otherwise be unable to.  The PST and TBT ETFs offer a leveraged view on Treasury Note performance.  Their performance is intended to correlate closely with double the inverse total return of different segments of the Treasury curve.

One downside to these ETFs is that rates must increase by enough to cover the coupons earned by the underlying securities.  In other words, unless rates rise by a large amount, an investor would still see her investment decline in value should the rate move be less than the coupon payments.

*Foreign Exchange ETFs –  These ETFs offer investors the opportunity to profit from a decline in the value of the U.S. dollar in relation to other currencies, without the difficulty of trading foreign exchange directly with a currency dealer.  If/when inflation becomes more pronounced as both capital account and current account deficits overwhelm the U.S. economy, the value of the dollar could fall.  These ETFs offer some measure of protection.  The CYB and UDN ETFs offer a short position in the U.S. dollar versus the Chinese Yuan and a basket of currencies (British Pound, Canadian Dollar, Euro, Japanese Yen, Swedish Korona, and Swiss Franc), respectively.

Of course, as inflation rises and the Federal Reserve attempts to fight it, the Fed could raise short-term interest rates (as Chairman Paul Volcker did in the late 1970s).  This could squeeze U.S. dollar shorts as the cost of financing those positions increases.

*Commodity ETFs — Like other ETFs, these funds make it easier for investors to gain exposure to a given asset class, in this case — commodities.  Precious metals such as gold are often considered the “classic” inflation hedge.  However, any commodity denominated in U.S. dollars can serve as an effective inflation hedge.  There are a variety of commodity ETFs available, including ones for gold (GLD), oil (USO), and grains (DBA).  There are also more generic commodity ETFs that cover a more diverse set products, such as the GSG ETF.  Essentially, in purchasing these ETFs, an investor is wagering on the relative value of these products against the U.S. dollar.  In a sense, buying equities accomplishes much the same thing.

*”Hard” Assets — Vacant land, a farm, even the house in which you live (if you own rather than rent) can serve as an effective inflation hedge.  This is perhaps the simplest and easiest way to hedge against inflation.  Simply by owning a home, one can protect against the ravages of inflation.  Owning a home can have a dual benefit, depending on how it is financed.  This leads to the next inflation hedge…

*Financing — As long as payments are affordable, financing a large (80%?) portion of any purchase on a fixed-rate basis, particularly one as large as a home, has several (inflation fighting) advantages.  For example, take a homebuyer who borrows money at, say, 6%.  If inflation and interest rates skyrocket, as occurred some thirty years ago (remember those 18% mortgage rates), not only has the borrower saved himself a huge opportunity cost, but he can essentially monetize his debt to the bank by investing any current savings/income in higher interest bearing instruments, effectively arbitraging the remainder of his loan.  Fixed-rate financing brings with it another built-in advantage — if mortgage rates drop, the homeowner can refinance (assuming adequate equity) at a lower rate, decreasing his monthly payments.  This exemplifies positive convexity, a key benefit of a mortgage’s refinancing option.

*Payer Swaption — This is The Lamb’s preferred means of inflation protection.  As a background note, The Lamb is a HUGE fan of insurance.  You name the insurance, The Lamb owns it —  health, property, life, long-term care — The Lamb’s got it all.  He likes the safety, the protection, and most of all, the peace of mind.  So, it should come as no surprise that The Lamb likes “payers” as inflation protection.  Like other insurance, a payer swaption can be thought of as an “option premium”, or the cost of buying insurance.  Your “downside” is that nothing happens, and all you’ve lost is the premium you paid for the insurance. 

While most insurance doesn’t pay off, and is viewed by some as a waste of money, try buying hurricane insurance in Miami when a Category 5 monster is in the Florida Straits — you may find it a tad expensive.  It’s the same with inflation.  Buying protection is cheapest before you see the whites of its eyes.

So, back to payer swaptions.  Essentially, payer swaptions give the buyer, in exchange for an upfront premium (just like insurance), the right (but not the obligation) to pay a pre-determined fixed interest rate for a certain period of time beginning at a certain time in the future.  Think of them as puts on interest rates.  For example, if you own a payer swaption struck at 6% and rates are at 8% when the put expires, you would exercise the option and pay a 6% interest rate when market rates are at 8% (as a practical matter, you would “cash settle” the trade, pocketing the present value of the difference between the two rates).

Payer swaptions can be utilized to garner inflation protection while only risking a small cash outlay.  As an example, a payer swaption giving the buyer the right to pay a 5.50% fixed rate (versus a series of floating three-month rates equal to LIBOR) for ten years, beginning in ten years, can be purchased for roughly 3% of the notional amount (e.g. — $30,000 for a $1,000,000 swaption).  A relatively small premium, an investor can lose 3% in just one day of stock market moves. 

If, in ten years, inflation and interest rates are higher, say even at just 7% (just above the average over the past 20 years, and far below the 10% in 1989, and the mid-teens reached a decade before that), the swaption would be worth approximately $100,000 — more than triple the initial premium.  What’s more, unlike other types of insurance, this insurance provides ten years worth of protection.

Via The Bloomberg (click on image for better view):

Historic 10YR Swap Rates

The Lamb has always been fascinated by the concept of hyperinflation — the rapid and extreme rise in the price of goods and services — (and by Michigan Football’s inability to stop a spread offense, but that’s another story).  The most fundamental causes of (hyper)inflation are an increase in the supply of money and/or a (corresponding) decrease in that money’s value.

Perhaps the most dramatic example of hyperinflation occurred in Germany during 1923-24.  Following World War I, the Allies forced Germany to sign the punitive Treaty of Versailles.  Among other things, the Treaty forced Germany to admit responsibility for the war and to pay for its damages.  The German economy, in tatters following the war, was unable to generate enough money to pay its debts.  The country embarked on a crash course of currency creation, running its printing presses non-stop.

This had the effect of quickly eviscerating the value of the German currency.  At the beginning of 1923, it took 9000 German Marks to buy one U.S. dollar.  One year later, the rate was 100 trillion marks to the dollar.  The country was futilely attempting to print its way out of debt, but only succeeded in making its currency next to worthless:

In Germany one morning in early 1924, a woman was on her way to the bakery to buy bread for her family.  Suddenly, a man accosted her, grabbing the bag she was dragging behind her which carried the trillions of marks she needed to buy bread.  As she begged him to return her money, he emptied the bills onto the street and replied, “Keep the money, I just want the bag.”

One Trillion Marks -- Almost Enough For Bread in 1924

Segue back to this side of the pond.  Congress has passed and the President has signed the now (in)famous $700 billion bailout/stimulus/rescue plan.  Now, $700 billion (the final tab could be less) may not be huge when compared to our roughly $14 trillion economy.  Yet, this spending/printing of dollars is all too typical of America’s solution to economic problems (see 1980’s Chrysler loan guarantee, 1989’s Savings & Loan bailout, and this year’s massive Bear Stearns backstop and AIG rescue, just to name a few).  Uncle Sam has even committed money to protecting over $2 trillion in money market fund assets — see the post 2 + a + 7 = 50,000,000,000.

One may argue that the Feds undertook a similar strategy in the 1930’s to counteract the consequences of the Great Depression, with relatively few ill effects from runaway inflation.  While we can debate the wisdom of New Deal programs, the fact is that the United States was a creditor nation then (an idea that is a distant memory now) and, more importantly, was on the gold standard.  Our current system of fiat money leaves us far more susceptible to a rapid decrease in the value of the dollar.

The Fed, under its last two Chairmen, has been more concerned with deflation than inflation.  They have targeted a low federal funds rate, or as The Lamb calls it, “growth at any cost.”  In fact, Fed Chairman Bernanke has given speeches bemoaning the dangers of deflation. Unfortunately, by the time inflation rears it ugly head the next time, it may already be too great to contain.

The deadweight loss created by the Troubled Asset Relief Program (TARP) is just the latest in a tragedy of financial errors — see the post Brother, Can You Spare 7 Trillion Dimes? And when considered alongside our roughly $800 billion current account debt (cumulative trade deficits) and our $10.1 trillion national debt (not to mention future expenditures for entitlement programs like Medicare and Social Security), you get total debt of nearly 80% of the U.S. gross domestic product (GDP) and rising…

Now, not even The Lamb, as long-term bearish as he is on the U.S. Dollar, believes that we are on the cusp of hyperinflation.  Though the Dollar has been on a terrible slide this decade (see chart below of the U.S. Dollar Index, courtesy of fxstreet.com), it has shown signs of life the past few months.

Look Out Below.....

However, the recent strengthening of the greenback is due largely to the ubiquitous need of corporations and banks to make outright purchases of needed dollars that they are unable to borrow in the credit markets for their ongoing financing activities.  The dollar may very well continue to rise until lending in the money markets returns to equilibrium.

But if/when the dollar restarts its slide, it may be swift. That may be a good time to put The Lamb’s Rule #7 into action — If you’re gonna panic, make sure you’re the first.

Severe inflation would have a few tertiary advantages for some.  Homeowners’ existing fixed-rate mortgages would effectively be wiped out as the dollar’s value plummeted, essentially producing mortgage-free homes.  Other hard assets, from cotton to coffee and from silver to soybeans, would also rise in value on a dollar-basis.  Those that owned these “real” assets would enjoy a modicum of protection from the ravages of breakneck inflation.

However, there would be a catastrophic downside.  Interest rates would soar and those lenders that hadn’t already been forced into bankruptcy would be wary of lending at all but the most punitive of terms.  Furthermore, the price of goods and services would soar as sellers sought to stay one step ahead of our crashing currency.  Commerce would screech to a halt.

Let’s remember, a slowing economy, even a recession, is not the end of the world.  It’s called the business cycle.  This country, actually most countries, go through periods of economic contraction.  This is a natural way for the economy to build a stronger and more stable base from which to maintain long-term growth.  As painful as economic slowdowns might be, they are far less deleterious than the flip side — runaway price increases.  See Zimbabwe’s current 531 billion percent inflation as a savage example.

Call The Lamb Chicken Little, but he’ll take a weak economy every now and then if it means he’ll never be emptying out a bag packed with cash just to make it easier to carry.

Disclosure: The Lamb owns UDN and CYB, two exchange-traded funds expressing bearish views on the U.S. Dollar.  The Lamb also owns GLD, a trust that buys and holds gold bullion.