Defend Yourself from the Fed with These New Inflation ETFs

Inflation can be deadly to your investments. It’s a silent killer, too — one that reduces your “real” asset value even when the “nominal” worth looks higher.

As my colleague Mike Larson said just a few weeks ago, the Federal Reserve and other central banks are printing money at a faster and faster rate. A weak global economy is letting them get away with it — for now. But eventually they will run out of ink.

The good news is that you and your investments aren’t helpless against the money-printing presses. And today, I’ll tell you about some new Exchange-Traded Funds that offer you a terrific chance to hedge yourself against monetary manipulation.

How to Measure Inflation?

Inflation is particularly damaging to bond investors. If you buy a 30-year bond with a 3 percent annual yield, but inflation also averages 3 percent, all you’ve done for 30 years is break even. If inflation runs 4 percent, then you are actually losing value.

Traditionally, investors tried to protect against this threat with tangible assets like gold. That’s still a good idea. In fact, I currently recommend a gold ETF in my International ETF Trader service.

Gold is the traditional inflation hedge.

With the introduction of Treasury Inflation-Protected Securities (commonly called “TIPS”), bond traders found a new way to measure inflation expectations. Unlike other Treasury bonds, TIPS bonds have a built-in inflation-adjustment feature, and you get paid the adjusted or original principal (whichever is greater) at maturity.

Together, the market prices of these two instruments give us some very useful information. Subtract the TIPS yield from the yield of a regular Treasury with the same maturity date. What you get is a measure of the expected inflation rate over that time period. This is called the “TIPS spread,” and I’ll show you in just a moment why this is important to know.

Several convenient indexes track this indicator at various maturity levels. Typically, the indexes are designed to go up when the bond market signals higher inflation expectations.

(Note here that we’re talking about future inflation expectations, which may or may not turn out to be right. It may also be different from the actual change in consumer prices.)

So what can you do with this kind of information? Until recently, not much. Now you have some new options.

Announcing: Inflation/Deflation ETNs and ETFs!

On Dec. 6, 2011, PowerShares launched a pair of Exchange-Traded Notes offering direct exposure to U.S. inflation and deflation expectations, the PowerShares DB US Inflation ETN (INFL) and the PowerShares DB US Deflation ETN (DEFL).

Both are based on indexes that measure the TIPS spread at three different maturities. Nominally, the five-year securities are weighted at 50%, the 10-year at 40% and the 30-year at 10%. The result is a blend of the market’s short-, medium- and long-term inflation projections.

The bond market anticipates inflation.

If market action signals higher inflation, you should see INFL go up in value while DEFL drops. If deflation is considered more likely, DEFL should outperform. If inflation is flat, then both should go roughly sideways (or drift down a bit due to their operating fees).

While PowerShares is a great outfit, I’m not a big fan of the ETN structure. The counterparty risk bothers me. (Click here to learn why.)

Fortunately, we have ETF alternatives, too.

The ProShares 30 Year TIPS/TSY Spread (RINF) and the ProShares Short 30 Year TIPS/TSY Spread (FINF) are similar in concept to INFL and DEFL.

One key difference, however, is that the ProShares benchmark index is tied strictly to the 30-year TIPS spread. This should result in RINF and FINF being more-sensitive to short-term changes in the inflation forecast.

You can’t go both directions at once!

As the name suggests, FINF (the short ETF) is an “inverse” variation of RINF (the long ETF). It will go down as RINF goes up, and vice versa.

There is no diversification benefit to owning RINF as well as FINF. In fact, owning both would be counterproductive because you’ll be working against yourself. The same is true for INFL and DEFL.

Bottom Line

Here’s a quick summary of how to use these new instruments.

• If you think inflation will go up, consider buying INFL and/or RINF.
• If you think deflation is the bigger problem, look at DEFL and/or FINF.

These aren’t the only ways to protect your investments against inflation or deflation. As I said above, gold funds and other traditional hedges can work, too. These new instruments offer a laser-focus on the TIPS spread without other complicating factors. This gives them many potential uses. Check them out.

Best wishes,

Ron

P.S. For the best ETFs to invest in — with complete details on what and when to buy and, more importantly, when to cash out — join my International ETF Trader service. Click here to get started today!