What is an Inflation Trade
An inflation trade is an investing scheme or trading method that seeks to profit from rising price levels influenced by inflation. Inflation trades are common in times of rising price inflation. Inflation trade can refer to the shifting of a portfolio. It may also refer to speculative trades involving assets highly susceptible to price inflation such as the dollar, gold or silver.
BREAKING DOWN Inflation Trade
Inflation trade is a concept broadly considered when investors believe there is 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.
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 of time. Inflation can be influenced by the Federal Reserve which uses policy actions such as interest rate changes or the printing of money 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.
There are several key data reports that provide details and insight on inflation trends. Reports include the Consumer Price Index, the Producer Price Index and the Personal Consumption Expenditures Index.
Inflation Trades and Arbitrage
Generally consumers must consider the effects of inflation on their spending and their investment portfolios. Annual inflation can be as high as 2% to 3% in expanding economies. Therefore prudent investors will typically make some effort to preserve the value of the wealth they have accumulated and protect it against inflation effects. In times of rising inflation, many investors are advised to add or increase their exposure to TIPS. TIPS are one of the most popular products for hedging and protecting cash investments from the effects of inflation. TIPS offer investors interest payments that correspond with the inflation rate over time.
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 from inflation. Overall, inflation trade rotation in a portfolio will help investors outpace inflation while also increasing their potential upside.
Since inflation can often be predicted by data reports and economic trends it also offers 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. Thus, calendar spreads are a popular type of inflation trade. In a calendar spread on a commodity such as gold, an investor would use a near-term contract to buy gold and a long-term contract to sell gold at a higher price. In this inflation trade calendar spread the investor’s profit would be the difference between the long-term term selling price and the near-term buying price plus or minus any costs from the derivative contracts. Bets on currency fluctuations and the dollar’s appreciation versus other foreign currencies are also applicable for inflation trades.