What Is an Inflation Hedge? Finding Stability in Today's Market

When inflation runs rampant in an economy, it is difficult to find a lifeboat that can reliably protect you from volatility. A JPMorgan conference recently conducted a survey and 47% of respondents listed commodities as the most effective inflation hedge. 27% listed equities, 10% listed securities and 17% listed other.

But this survey was conducted when many believed our current inflation to be transitory. Now, inflation appears to not only be persistent, but global. The landscape has changed. Russia’s invasion of Ukraine, the economic slowdown in China, and the rising US dollar have all driven volatility in the commodities market. Traditional inflation hedges have all seen similar effects.

In our previous two articles of this series, we learned that the world needs asset-backed currencies that can resist censorship and provide long-term purchasing power. But to better understand what type of assets are required, we need to understand how investors and everyday people hedge inflation.

Stabilize Money Stabilize the World

Part 1: What’s broken
Why unstable money isn’t safe for the world and how to understand monetary policy
Part 2: What are people doing today about it?
A dive deep into the types of monetary policy alternatives that stablecoins offer
Part 3: What is the right way forward?
A guide to the various inflation hedging tactics and how they can be used in stablecoins
Part 4: What will the future look like?
A look at how tokenization will change the stablecoin ecosystem
About our sponsor: Reserve
A video explaining the Reserve Protocol

What is an inflation hedge?

An inflation hedge is any investment intended to protect the investor from the effects of a currency’s increasing money supply and decreasing purchasing power. Popular hedging strategies typically include physical assets with limited supplies and are not only reserved for the investing class. Citizens of nations with hyperinflated currencies need inflation hedges to conduct business and survive the rising cost of living.

While it is natural to assume that harder assets are less resistant to inflation, not all provide the same degree of protection. Macroeconomic forces make it difficult to predict how these assets will perform compared to a declining currency.

So investors typically aim to create a diverse portfolio with various investments to hedge inflation effectively. At times, this may include advanced options and derivatives trading strategies. But for this article, we will compare the effectiveness of six asset classes: fiat, commodities, bonds, real estate, digital assets, and others.

Fiat

Fiat currencies are naturally inflationary, so how can they be inflationary hedges? Citizens in nations with currencies facing much higher inflation rates can hedge their investments by buying another fiat currency inflating at a lower rate.

For example, a citizen of Argentina is unlikely to buy more of their national currency, the peso, to hedge against inflation. The peso is a notoriously weak fiat currency that constantly loses value through centralized, controlled monetary policies. Venezuelans swap their peso for the US dollar to hedge the peso’s inflation.

Even though the US dollar is also losing purchasing power, it’s declining at a much lower rate, meaning that by buying USD with bolivars, you’ll lose less money over time. This is, of course, assuming you have an easy and affordable way to exchange your local fiat for USD, something that the Reserve app is making possible.

In this environment, buying the currency with a lower inflation rate can keep more of your purchasing power than if you just kept your local currency.

Digital assets (cryptocurrencies)

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Cryptocurrency advocates have long argued that digital assets are some of the best ways to hedge against inflation. Their fixed supplies or deflationary mechanics are inherently designed to make the currencies anti-inflationary.

However, not all digital assets are intended to replace fiat currencies. Some, like bitcoin, are considered digital stores of value — a digital equivalent to gold. Bitcoin evangelists argue that energy expended to produce bitcoin provides important security for a scarce asset. But because it represents a new asset class, the market for these standalone digital assets is highly volatile — resulting in significant price swings in short periods.

Secondly, some experts believe that “Bitcoin is not immune to macroeconomic factors.” Meaning that despite having a fixed supply, these forces influence demand in a similar way that they influence the stock market.

2022 is tracking at an 8.2% inflation rate, and BTC is down 59.46% YTD. That means that $100 from January this year is now worth $91.8, but $100 worth of bitcoin is worth $40.54.

Bitcoin holders will point to the asset’s long history of price appreciation to argue that it makes for a better inflationary hedge in the long run. But in times of great volatility, the asset provides poor purchasing power. Someone in Argentina is less inclined to use bitcoin to buy a bag of groceries when it is down 20% that day.

Read more: Why Unstable Money Isn’t Safe

Commodities

Commodities have traditionally been a reliable inflation hedge. According to Vanguard, commodities rose by 7% to 9% for every 1% of unexpected inflation over the last decade. The universal and persistent demand of this asset class makes it inherently valuable. But while they may be a great addition to an investment portfolio, they do not offer consumers a solution to their declining purchasing power.

For example, when inflation fears are high, supply constraints make physical gold more expensive than its spot price. If someone in a hyperinflationary environment wants to buy gold for the purpose of retaining purchasing power, they need to pay the premium and hope that the spot price continues to rise. This becomes a difficult gamble for families that simply want to put food on the table. Similar supply and storage constraints make commodities like oil even more difficult to use as a hedge in this environment.

Government Bonds

Government bonds, unlike stocks, are fixed-income debt instruments backed by the issuing government. Though the potential rate of return is generally lower than investing in stocks, bonds can provide a steady and predictable stream of income from the borrower.

Government bond yields have an inverse relationship with the market, so investors often use them to hedge against the risk of recession. The Federal Reserve has implied that economic growth needs to decline more to prevent runaway inflation. The Fed hopes to achieve this through raising interest rates and thereby increasing the cost to do business.

If the Fed succeeds, then bonds may offer a hedge against the declining economy, but if it fails, bonds can only offer an inflationary hedge if the interest rate outpaces inflation.

Real estate

Investing in real estate can be one of the best ways to hedge against inflation, but there are a couple of caveats. The first is timing. Investing in real estate during times of high inflation can be a poor decision because the interest rates on loans are likely to be quite high, making it an increasingly expensive debt to pay off.

The reality in this scenario is that real estate prices are lower during these times. Those with access to capital have a major advantage and are able to buy real estate outright.

Those that bought houses on mortgages leading up to the 2008 Financial Crisis likely didn’t do well, but those that bought during the crisis are likely reaping huge rewards today.

Timing is everything with real estate. It’s best to only add real estate when it can either generate income in the form of rentals or when you’re in a strong financial position, allowing you to buy at low prices and wait for a good time to sell.

Finding stability in a diverse portfolio of stable assets

Realistically, the best inflation hedge would be a portfolio full of stable assets that have steady value and can generate passive income for the investor. However, assembling a portfolio full of stable assets is easier said than done, with every asset sector facing fairly large price swings.

People have historically done this in a variety of different ways. One of the most popular arising in the last 20 years or so is the “60-40” portfolio of diversified equities and bonds. The theory is that if 60% of the portfolio is made up of growth stocks and real estate, then it will capture the gains of a growing economy. The latter 40% of government bonds help protect the portfolio from regional recessions.

The dragon portfolio is a new alternative to the 60-40 investing strategy. It was developed to account for two opposing economic environments. The first, represented by a serpent, is an era of great economic expansion — sustained by technological advancements and global trade. The second, represented by a hawk, is a prolonged era of deflationary change. As the serpent grows old and over-inflated with bad debt and poor monetary policy, the hawk makes its strike and the world undergoes a painful period of restructuring.

The dragon is a representation of both creatures and is designed to grow wealth throughout the entire cycle. It is still new and hasn’t been adequately tested. It comprises 24% equities, 19% gold, 18% commodities, and 18% fixed income.

But to properly assist people in retaining purchasing power, there needs to be a way to make inflation hedges portable.

This is why Reserve’s end goal is to facilitate digital currencies backed by baskets of stable-value assets, providing an alternative to the reliance on a fiat monetary system.

Reserve’s inflation hedge philosophy

Reserve hopes to empower people across the world to not only choose their own monetary policy, but make their own. They want to create a free market of asset-backed stablecoins that can offer a better alternative to the broken fiat system — one that is equally stable in the short run, and much more stable in the long run.

The assets that will back RTokens may vary by use cases, and could be a combination of digital assets such as ETH, BTC and other stable DeFi assets, as well as tokenized versions of real-world assets such as commodities and real estate.