Inflation Trade: What it is, How it Works

What Is an Inflation Trade?

An inflation trade is an investing strategy or trading method that seeks to profit from rising price levels influenced by inflation or expectations of coming inflation.

Understanding Inflation Trade

Inflation trades are common in times of rising price inflation or in times when investors expect the Federal Reserve (Fed) to change rates significantly over the coming months. Inflation trades can refer to the shifting of portfolio assets, or it may also refer to speculative trades involving assets highly susceptible to price inflation, such as the dollar, gold, or silver.

Inflation trade is a concept broadly considered when investors believe there is the risk or potential to gain from rising price inflation. In times of rising price inflation, many investors will rotate their portfolios into assets generally more favorable in an inflationary environment.

Treasury inflation-protected securities (TIPS) are a top recommendation for investment portfolios when inflation is on the rise. Sophisticated investors and traders can also make targeted speculative trades using derivative instruments to orchestrate inflation trades that seek to capitalize on rising future prices.

Research has shown that stock portfolios can get some benefit from attempting to hedge against inflation. However, that hedge may come at the cost of increased volatility if not allocated properly. If the hedge is not over allocated, the results might be useful for some investors.

The most commonly considered hedge for inflation, for example, is the price of gold. Investing in the price of gold is roughly approximated by allocating money to an index fund such as the SPDR Gold Trust Exchange Traded Fund ticker symbol GLD. From mid-2018 into early 2019, inflation expectations had a significant impact on the market. This chart shows what might be experienced by a hypothetical investor who had allocated one-third of their portfolio to GLD and two-thirds of their portfolio to SPY.

Notice in this chart that the purple line (representing the hypothetical portfolio) showed less volatility through this period, and when the market dropped significantly in late 2018 (marked by the black rectangle), the price of GLD began to rise. This kept the hypothetical portfolio from falling as far as the S&P 500 stock index (marked by the black arrow).

The negative aspect of this is that this portfolio mix does not perform as well as stocks when the S&P 500 index is doing very well. But the example does show how the mix reduces portfolio volatility and can provide investors some protection against inflation worries.

Inflation

Inflation is an economic mechanism influenced by various market factors. It is typically expressed as a percentage. It refers to the incremental price increase that a consumer is charged for goods or services over a specified period. Inflation can be influenced by the Federal Reserve which uses policy actions such as interest rate changes to control inflation. High inflation can be a detrimental force that erodes the value of money. It means that people cannot buy as much with their money tomorrow as they can today. Inflation also reduces the impact of investment earnings and makes it risky to hold too much of one's nest egg in cash.

Several key data reports provide details and insight on inflation trends. Reports include the Consumer Price Index (CPI), the Producer Price Index (PPI), and the Personal Consumption Expenditures (PCE) Index.

Inflation Trades and Arbitrage

Consumers often consider the effects of inflation on their spending and their investment portfolios. In expanding economies, the Fed's targeted annual inflation rate is typically in the 2% to 3% range. Dramatic spikes can occur due to macro-economic or geopolitical events, such as recent trends that have pushed inflation in 2022 near multi-decade highs of 9%.

Prudent investors will typically attempt to preserve the value of their wealth and protect it against the effects of inflation. As inflation rises, many investors are advised to add or increase their exposure to TIPS or I-Bonds. TIPS and Series I-Bonds offer investors interest payments that correspond with the inflation rate over time.1

In times of rising inflation, TIPS are typically favored over government bonds in investment portfolios. Cyclical stock sectors, such as technology, are another category that investors typically rotate into when prices are rising due to inflation. Overall, inflation trade rotation in a portfolio will help investors outpace inflation while also increasing their potential upside.

Since inflation can often be forecast by data reports and economic trends, it can offer an opportunity for arbitrage trading through the use of derivatives. Therefore, an inflation trade can also be a type of speculative arbitrage transaction that seeks to gain from bets on price increases. Inflation trades can take various forms.

Generally, an inflation trade will involve derivative contracts that provide for profits from rising future prices. Bets on currency fluctuations and the dollar’s appreciation versus other foreign currencies are also applicable for inflation trades.