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Tips and Gold to hedge uncertainty

In View: Players? turn to Tips and Gold to hedge uncertainty In Y 2002, Ben Bernanke deemed deflation such a threat to the US economy that he referred to Milton Friedman's "helicopter drop", the figurative notion of handing out cash to the public to stop falling prices, in one of his most memorable speeches. Today deflation is arguably a graver threat, as US inflation is much lower now than it was then. This poses big problems not just for the US Federal Reserve chairman but for investors too. One of the best gauges of inflation in the US, the Cleveland Fed inflation measure, shows the US closer to deflation than at any time since Y 1990. Fear that prices can surge in 2 to 3 yrs still troubles many players, not least because leading commentators believe further rounds of quantitative easing, the buying of bonds to stimulate the economy, are looking more likely on both sides of the Atlantic. In recent weeks, many fund managers have responded by rolling into 2 asset classes that are likely to perform well in either scenario: index-linked Government Bonds and Gold. Inflation-linked bond yields in the US, UK and the EuroZone are trading around all-time lows, while Gold prices have risen to record highs as they are also considered worthwhile assets to hold in a deflationary environment. Indeed, index-linked bonds in the biggest three markets of the US, UK and France are trading with negative yields, something that has never happened until this year as fund managers seek out the safest assets to preserve cash. Gold, meanwhile, has risen to about US$1,250 oz, more than 100% higher than levels of only 3 to 4 yrs ago. Since the start of the year, Gold has risen by 12%. These 2 asset classes are seen as attractive in either a deflationary or inflationary climate, making them popular with fund managers who have no concrete idea how the Global economy will unfold. Deflation may be considered a more near-term problem. But inflation concerns rise over the medium to long term because of the dangers of central bankers over-egging their response to the threat of falling prices. US Treasury inflation-linked securities (Tips) are one. An investor who buys Tips is guaranteed par value of 100 at maturity, even in the event of deflation. So if a fund manager buys at 100, he is protected against both deflation and inflation. Although index-linked bonds in the UK, France and other markets do not have this protection against deflation, they are still seen as a good bet by many fund managers in a deflationary scenario as they are likely to outperform other assets such as equities. In other words, a sharp reversal of the World economy would probably see fund managers take heavy losses in equities, commodities and on many foreign exchange markets. So, "Linkers" or Gold are seen as likely to outperform. Other strategists say the odds of deflation are still low, making a safe asset that traditionally protects against inflation a good buy. Alex Li, strategist at Deutsche Bank, calculates the odds of deflation in the US at about 23% based on real yields, which take into account inflation, over 5 yrs and about 14% on real yields over 10 yrs. But break even rates, the difference between yields on conventional government bonds and inflation linked bonds, considered the market's best measure of inflation, suggests moderate inflation over the next few years. For example, for benchmark 30 yr Bonds, break even rates are more than 2% in the US and France and above 3% in the UK, suggesting inflation will average in excess of 2% annually for the next 30 yrs in all 3 economies. A low-growth, low-inflationary environment is likely to see conventional Government Bonds and "Linkers" climb higher with their yields falling further. Gold could benefit in such a climate as well. If growth falters or economies move closer to deflation, index-linked bonds could see further upside too. While index-linked bonds will perform less well if investors anticipate a long period of low inflation, real yields too can certainly fall further from here if growth worries intensify.---Paul A. Ebeling, Jnr. www.livetradingnews.com