Investment Advice, 4/13

I might be giving it, or I might be asking for it

John Cochrane is puzzled by the Fed’s timidity in fighting inflation.

What is the core belief differentiating the Fed view from the traditional view? I think it is the effect of real rates on inflation. In the Fed's outlook, there is still a substantial period in which inflation is higher than nominal rates, so the real rate is negative. In the Fed's outlook, this period of negative real rates does not constitute additional monetary stimulus that sends inflation higher. The "temporary" shocks fade away, despite the negative real rates. In the traditional view, this period of negative real rates itself creates additional stimulus, and additional shock pushing inflation higher.

I have the traditional view, which leaves me puzzled. If the traditional view is correct that negative real interest rates will drive inflation higher, holders of bonds are going to lose purchasing power at an alarming rate.

The traditional view is that in order to get inflation under control, the real interest rate (the interest rate minus the rate of inflation) is going to have to rise. If that is the case, then inflation-indexed bonds may not be such a great investment right now. Think of an inflation-indexed bond as a real bond, meaning a bond that pays the current real interest rate. If real interest rates have to rise in order to stop inflation, then real bonds have to lose value. Possibly a lot of value.

I think this is the most difficult environment that I have ever seen for trying to come up with investments that will preserve their value in terms of purchasing power. Let me try to explain why.

Real interest rates are mostly negative right now, because inflation is so high. In the traditional view, that is not sustainable. Either inflation will get worse and worse, or at some point interest rates will rise above the inflation rate, to make real interest rates positive.

Negative real rates are a benign environment for buying growth stocks, commodities, real estate, Bitcoin—just about anything other than fixed-income securities. If the traditional view is wrong, then this environment will persist. What’s gone up since five years ago will continue to go up.

But if the traditional view is right, then at some point we will get a regime shift, in which interest rates rise significantly. After the regime shift, fixed-income securities will be able to beat inflation. But during the regime shift, bonds and everything else will go down in price. On top of that, inflation will continue to erode purchasing power. No investment will be safe.

(Some of you are going to tell me that Bitcoin will keep going up during the regime shift, because Bitcoin is like no other financial asset that has ever existed before, and in the long run, Bitcoin can only go up, and you are going to end up in libertopia, powered by Bitcoin. You may be right, but suffice to say that is not the traditional view.)

For someone with the traditional view, the financial strategy that makes the most sense is to buy put options on Treasuries. But I have not yet talked myself into doing that.