Part two of a three-part series on inflation hedging strategies

In part one of this series (published in the October 19, 2009, issue of ING Investment Weekly) we acknowledged that TIPS, commodities and real estate investments are widely employed as inflation hedges. However, our research found that these investments, while offering portfolios clear diversification benefits, are only loosely correlated with inflation. Their hedging attributes are muted due to the disproportionate impact on returns exerted by other risk factors independent of inflation.  We concluded that investors needing to combat inflation on a short-term basis may be better served by synthetic inflation hedges benchmarked to LIBOR.

LIBOR (London Interbank Offered Rate) is the interest rate at which banks can borrow funds from one another on an unsecured basis. The British Bankers' Association derives this benchmark daily from an average of interbank deposit rates for large loans offered by the world’s most creditworthy banks. A LIBOR benchmark is produced for 15 different maturities — ranging from overnight to 12 months — with each denominated in ten different currencies — U.S. dollar, British sterling, euro and Japanese yen being the most prominent.* In addition to loans, LIBOR is commonly used as a reference rate for a variety of financial instruments, including certain types of futures, options and swaps.

We compared a monthly series of trailing 12-month returns of three-month LIBOR rates to year-over-year headline inflation; i.e., the Consumer Price Index (CPI), a weighted average of the prices of a basket of consumer goods and services. Since interbank rates adjust quickly to reflect inflation expectations, we see a high and stable correlation with year-over-year inflation rates as reflected in LIBOR and CPI.  Furthermore, this pattern is consistent across regions and monetary regimes; the graphs below illustrate the historical relationships between inflation and interbank lending rates in the U.S., eurozone and U.K.
 

 

 


Source: Bloomberg, British Bankers’ Association, Bureau of Labor Statistics, European Commission, U.K. Office for National Statistics. U.S. CPI is U.S. CPI Urban Consumers Non-Seasonally Adjusted. Euro CPI is the Eurostat Eurozone MUICP All Items. U.K. CPI is the U.K. CPI EU Harmonized YoY Non-Seasonally Adjusted. All CPI is shown year-over-year and rolled forward monthly. All LIBOR data reflect rolling 12-month returns. Each data point in the three-month LIBOR series is the annual rate prevailing on the last day of a given month.
 
Why LIBOR?

Strategies such as TIPS, commodities and real estate are touted as being responsive to changes in inflation rates; while this is true over long time periods, investors who desire near-term inflation protection may be disappointed. LIBOR, on the other hand, is highly responsive to inflation due to the interaction between interbank lending rates and monetary policy.

Most central banks, particularly in developed economies, use monetary policy as a tool to control inflation (among other things). Generally speaking, policymakers raise target rates to combat rising inflation and reduce rates to stoke economic growth. Regardless of whether central bank rates are the result of hawkish or dovish monetary policy, interbank rates will usually be higher than the rate of expected inflation and will correlate well with realized inflation. Further, given that monetary policymakers are unable to set nominal rates below zero even in a shrinking economy, LIBOR-based returns can be attractive in both inflationary and deflationary environments.
 
As indicated in the graphs, our research shows that interbank lending rates:

n typically outperform realized inflation

n have lower volatility than other inflation hedging instruments

n have high and stable correlations with realized inflation
 
Thus, interbank lending rates are a viable benchmark for an inflation hedging program. Given the characteristics cited above, we believe that using a highly liquid LIBOR index provides greater potential to meet or exceed CPI than does a strategy employing TIPS, commodities or real estate, especially over short-to-medium time horizons.  Nevertheless, while LIBOR-based strategies may reliably produce a return in excess of inflation, this spread is most likely insufficient to satisfy the funding objectives of most investors. We will address a potential solution to this conundrum in our third and final piece on inflation hedging in an upcoming issue of ING Investment Weekly. n
 
 
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This report does not make any recommendation about your investments, and this information should not be considered investment advice. Any opinions expressed herein reflect our judgment at this date and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management's current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels and (4) increasing levels of loan defaults (5) general competitive factors (6) changes in laws and regulations (7) changes in the policies of governments and/or regulatory authorities. ING Investment Management assumes no obligation to update any forward-looking information contained in this document. Past performance is not indicative of future results.