Inflation Fears Are Back Again

For years, investors have expected that an increase in interest rates was imminent. With bond rates falling to record-low levels, it appeared that they had nowhere to go but up. Fast-forward nearly four years later, though, and the Federal Reserve's reduction of the Fed Funds rate as low as it could go hasn't succeeded in jump-starting the economy back to its pre-crisis turbocharged levels.

The silver lining of low rates and a weak economy has been that inflation has largely been in check. But with the Fed's latest round of quantitative easing, investors are now convinced that inflation is about to rear its ugly head. And more important, they're putting their money where their mouths are. Let's take a look at how investors are getting ready for inflation.

Last week's QE3 announcement played havoc with financial markets. For stock investors, the news was almost universally positive. But the bond market told a much different story.

In one part of the bond market, rates on regular long-term Treasury bonds soared and bond prices tumbled as traders grasped the magnitude of the announcement and the dedication of the Fed to bring about economic growth whatever the cost. Given that investors had used Treasuries as a safe haven to park money that they might otherwise have earmarked for stocks, greater optimism about the stock market brought about a corresponding exodus from bonds. Perhaps the best sign of this was movement in the bond-bearish ProShares UltraShort 20+ Year Treasury ETF (NYS: TBT) , which climbed more than 5% in a single day last Friday in response to the big move.

Yet one oft-ignored niche of the bond market went the opposite direction. Treasury inflation-protected securities, also known as TIPS, whose face value is tied to inflation by means of the Consumer Price Index, soared in value, with inflation-adjusted interest rates actually falling substantially on the day. The iShares Barclays TIPS Bond ETF climbed more than 1% during the final two days of last week. Investors were so hungry for inflation protection that they bid the real yield on the 20-year TIPS down into negative territory, meaning that they were willing to accept a guaranteed loss of purchasing power just to get a measure of protection against rising prices.

Bonds aren't the only investments out there pointing to at least the possibility of higher inflation down the road. Gold, which many use as a hedge against inflation, soared last Thursday, with SPDR Gold (NYS: GLD) jumping about 2% as the bullion-owning ETF climbed in sympathy with spot gold prices. Central Fund of Canada (NYS: CEF) , a closed-end fund that owns a combination of gold and silver, saw even more impressive gains of about 3%.

In fact, inflation may well have been responsible for a decent part of the gains in the broader stock market, especially among large-cap stocks. Powerful companies with loyal customers and valuable brand presence are often an excellent way to hedge against potential inflation, as these companies have the most pricing power and are better able to pass on any higher input costs to consumers rather than having to accept tighter margins and eat those costs themselves. For instance, both Starbucks (NAS: SBUX) and McDonald's (NYS: MCD) passed on higher costs for coffee and food ingredient prices to customers by raising menu prices, a move that less dominant players in the industry can't do without the threat of losing critical market share.

The evidence isn't totally conclusive, though. One contrary sign against inflation is the price of oil, which initially rose after the QE3 announcement but has since fallen well below its pre-announcement price.

Even though the jury's still out, inflation fears seem to be getting back on everyone's radar screen. Be sure to keep your eyes open to the impact of higher costs on the businesses whose stocks you own, and consider the effect of inflation whenever you make an investment. When inflation finally does make its comeback, you'll be glad you did.

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Fool contributor Dan Caplinger thinks he's as ready for inflation as he'll ever be. You can follow him on Twitter @DanCaplinger. He owns shares of Central Fund of Canada. The Motley Fool owns shares of Starbucks. Motley Fool newsletter services have recommended buying shares of McDonald's, as well as writing covered calls on Starbucks and writing puts on ProShares UltraShort 20+ Year Treasury. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gives you nothing to fear.

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