De-risking, inflation and forward risk tolerance

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Independent George
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De-risking, inflation and forward risk tolerance

Post by Independent George »

I turned 44 this year. Looking back over the last 20+ years, I've been able to handle market risk without undue worry, at least partly because I've always held on to a substantial cash reserve to get me through tough times.

On the other hand, I've never experienced a period of high inflation. I technically lived through the last vestiges of stagflation in the early 80s, but I've never actually experienced it at a time when I understood what it was, or had assets to worry about. I can look at numbers on a spreadsheet, but I have no idea what emotional impact seeing my hard-earned cash go up in smoke would be (to say nothing of the secondary effects on the economy as a whole).

Since inflation is itself a direct threat to the cash reserve, how do I account for that in my financial plan? I wrote my IPS largely without even thinking of inflation (other than to use inflation-adjusted targets for net worth at different ages). To mitigate stock market risk, I'm supposed to steadily increase my bond holdings starting next year. To mitigate job risk, I'm also supposed to increase my cash reserves from 6 months to 12 months. But I never even thought about inflation, and both of those things would be absolutely terrible in a high-inflation environment.

On the other hand, I also have a mortgage; does the pain of my cash being inflated out of existance get cancelled out by my debts likewise being inflated away? Is it worth suspending or reducing my extra principal payments if the dollar plummets? I have no idea; the entire concept is kind of alien to me. I can look at a spreadsheet and say it's dumb to pay down a 2.8% mortgage when CPI is at 8%; does it actually feel any better to have debt that gets devalued every year? Up until now, I've always been able to cut expenses when times were tough; how does one do that if prices are rising? How do you evaluate what 'six months' of expenses are when those expenses keep going up?

This is uncharted territory for me, and I have no idea what behavioral traps to even watch out for. How do I plan for something which I have no emotional context for? At the moment, this is all currently in the theoretical stage, but that can change at any time. How do I prepare?
Ocean77
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Re: De-risking, inflation and forward risk tolerance

Post by Ocean77 »

The best way to prepare is to relax and ignore the media. The dollar is not going to "plummet" and your cash is not going up in "smoke". Maybe after years of inflation between 1 and 2% (or less), we'll get 3 % for a while. Even if it spikes a bit higher, it's not going to be dramatic. Moreover, since most everybody expects some inflation increase now, perhaps we're not going to get any. When everybody expects something, the market usually does something different.

With stocks and a home, you already have assets that will stay ahead of inflation in the long run. If you want to do something more, put some part of your bond holdings into TIPS or iBonds, if not done already. Or add a (small) allocation to gold. But don't go overboard with this. And keep your emergency fund in cash.
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watchnerd
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Re: De-risking, inflation and forward risk tolerance

Post by watchnerd »

Ocean77 wrote: Tue Apr 06, 2021 7:13 pm The best way to prepare is to relax and ignore the media. The dollar is not going to "plummet" and your cash is not going up in "smoke". Maybe after years of inflation between 1 and 2% (or less), we'll get 3 % for a while. Even if it spikes a bit higher, it's not going to be dramatic. Moreover, since most everybody expects some inflation increase now, perhaps we're not going to get any. When everybody expects something, the market usually does something different.
Expected 10 YR breakeven inflation right now is 2.36%.

The market isn't signaling massive long term inflation.
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learntoinvest123
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Re: De-risking, inflation and forward risk tolerance

Post by learntoinvest123 »

Having similar concerns as yours, my plan is as follows
1) Cash reserves limited to Emergency cash ( 6 or 12 months depending of job situation, lower the better).
2) International diversification - I am moving towards 50/50 allocation. International seems cheaper than US and good protection against dollar value loss.
3) All Bond holdings are short term. 1-2 year range.
3) Watch CPI and treasury auctions. Treasury auctions are the surest thing about market's faith in US debt and are not controlled by Fed.
4) If yields rise beyond 2%, buy Gold on dips. Buy more gold if Fed continues to be dovish when yields are over 2%. I currently have zero gold exposure.
5) Keep mortgage high.

By letting inflation run hot, the Fed is giving hard asset investors free money by punishing fixed income investors. We should be fully invested in those.

I don't think the US will ever have runaway or persistent inflation. I can't predict what a Greece style meltdown looks like. Gold will appreciate significantly for sure. Money will flee US markets but I have no clue where it will go. Treasuries are seen as the only safe haven, if that is not so anymore I have no clue what happens.
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Oicuryy
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Re: De-risking, inflation and forward risk tolerance

Post by Oicuryy »

Independent George wrote: Tue Apr 06, 2021 5:39 pm Since inflation is itself a direct threat to the cash reserve,
What makes you say that? Cash in the bank held its own against inflation in the 1970s.

Image
https://fred.stlouisfed.org/graph/?g=CVSH

Ron
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watchnerd
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Re: De-risking, inflation and forward risk tolerance

Post by watchnerd »

Oicuryy wrote: Wed Apr 07, 2021 12:16 am
Independent George wrote: Tue Apr 06, 2021 5:39 pm Since inflation is itself a direct threat to the cash reserve,
What makes you say that? Cash in the bank held its own against inflation in the 1970s.

Ron
In their paper on TIPS and commodities, among the assets compared, Vanguard showed cash as having the highest correlation with expected inflation.
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alluringreality
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Re: De-risking, inflation and forward risk tolerance

Post by alluringreality »

Independent George wrote: Tue Apr 06, 2021 5:39 pmTo mitigate job risk, I'm also supposed to increase my cash reserves from 6 months to 12 months. But I never even thought about inflation, and both of those things would be absolutely terrible in a high-inflation environment.
One long-term way that I personally see to address this sort of item currently is I bonds. They have a 30 year term, they can't be sold in the first year, three months of interest is forfeited if sold before 5 years, they have yearly purchase limits, and they have no principal risk. I started moving my near-term assets into savings bonds after near-term rates were lowered in 2019. The current fixed rate on I bonds is 0% real, so you pay federal taxes on gains from inflation. Higher tax brackets or high inflation can potentially favor TIPS in a tax-advantaged account, but currently TIPS prices are fairly expensive compared to historical rates, which tends to favor I bonds for limited-term considerations. If high inflation happened, I suppose TIPS prices could actually go higher, but principal risk for TIPS might be a consideration if buying long-term TIPS for near-term considerations. I can certainly understand why I bonds don't work for all considerations, yet they're a fairly unique option for limited-term assets in the current market rate environment.
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cheezit
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Re: De-risking, inflation and forward risk tolerance

Post by cheezit »

Oicuryy wrote: Wed Apr 07, 2021 12:16 am
Independent George wrote: Tue Apr 06, 2021 5:39 pm Since inflation is itself a direct threat to the cash reserve,
What makes you say that? Cash in the bank held its own against inflation in the 1970s.

Image
https://fred.stlouisfed.org/graph/?g=CVSH

Ron
3-month T-bills are not a good proxy for "cash in the bank" over that period, given that Regulation Q capped interest rates in FDIC-insured savings accounts through March of 1986:
Image
( Also,the chart you care about is one plotting the integral of those curves)

This is why NOW accounts, money market funds, etc. sprung into existence in the '70s and early '80s.




Nb. that even T-bills have trailed inflation since the current era of monetary policy began: QE1 started in November of 2008, and from then to today T-bills have had a compound real return of -1.22% annually (so about 14% cumulative purchasing power loss from then through March 2021).
aristotelian
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Re: De-risking, inflation and forward risk tolerance

Post by aristotelian »

You could reduce the duration of your bond allocation. Should inflation rise in response to inflation, you will not want to be locked into long term bonds at low rates. The risk of short term bonds going down is much lower. Of course, the long term expected return is lower as is potential for going up should interest rates fall in a market crash.
case_of_ennui
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Re: De-risking, inflation and forward risk tolerance

Post by case_of_ennui »

alluringreality wrote: Wed Apr 07, 2021 7:23 am
Independent George wrote: Tue Apr 06, 2021 5:39 pmTo mitigate job risk, I'm also supposed to increase my cash reserves from 6 months to 12 months. But I never even thought about inflation, and both of those things would be absolutely terrible in a high-inflation environment.
One long-term way that I personally see to address this sort of item currently is I bonds. They have a 30 year term, they can't be sold in the first year, three months of interest is forfeited if sold before 5 years, they have yearly purchase limits, and they have no principal risk. I started moving my near-term assets into savings bonds after near-term rates were lowered in 2019. The current fixed rate on I bonds is 0% real, so you pay federal taxes on gains from inflation. Higher tax brackets or high inflation can potentially favor TIPS in a tax-advantaged account, but currently TIPS prices are fairly expensive compared to historical rates, which tends to favor I bonds for limited-term considerations. If high inflation happened, I suppose TIPS prices could actually go higher, but principal risk for TIPS might be a consideration if buying long-term TIPS for near-term considerations. I can certainly understand why I bonds don't work for all considerations, yet they're a fairly unique option for limited-term assets in the current market rate environment.
I'm beginning to roll my "emergency fund" into I bonds this year rather than a 0.5% CD. I procrastinated for a bit because of the hassle setting up a Treasury Direct account.
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Oicuryy
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Re: De-risking, inflation and forward risk tolerance

Post by Oicuryy »

cheezit wrote: Wed Apr 07, 2021 8:14 am 3-month T-bills are not a good proxy for "cash in the bank" over that period, given that Regulation Q capped interest rates in FDIC-insured savings accounts through March of 1986:

( Also,the chart you care about is one plotting the integral of those curves)

This is why NOW accounts, money market funds, etc. sprung into existence in the '70s and early '80s.

Nb. that even T-bills have trailed inflation since the current era of monetary policy began: QE1 started in November of 2008, and from then to today T-bills have had a compound real return of -1.22% annually (so about 14% cumulative purchasing power loss from then through March 2021).
All good points.

In the 70s and 80s my "cash in the bank" was actually CDs in S&Ls.

If the current era of monetary policy continues then the OP's cash will likely do no worse than it did during the past twelve years. And if monetary policy reverts to what it was in the 70's then the OP's cash will not "go up in smoke" or be "inflated out of existence". Mine wasn't.

Ron
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cheezit
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Re: De-risking, inflation and forward risk tolerance

Post by cheezit »

Oicuryy wrote: Wed Apr 07, 2021 9:47 am
cheezit wrote: Wed Apr 07, 2021 8:14 am 3-month T-bills are not a good proxy for "cash in the bank" over that period, given that Regulation Q capped interest rates in FDIC-insured savings accounts through March of 1986:

( Also,the chart you care about is one plotting the integral of those curves)

This is why NOW accounts, money market funds, etc. sprung into existence in the '70s and early '80s.

Nb. that even T-bills have trailed inflation since the current era of monetary policy began: QE1 started in November of 2008, and from then to today T-bills have had a compound real return of -1.22% annually (so about 14% cumulative purchasing power loss from then through March 2021).
All good points.

In the 70s and 80s my "cash in the bank" was actually CDs in S&Ls.

If the current era of monetary policy continues then the OP's cash will likely do no worse than it did during the past twelve years. And if monetary policy reverts to what it was in the 70's then the OP's cash will not "go up in smoke" or be "inflated out of existence". Mine wasn't.

Ron
That seems fair. The nightmare scenario where there is high inflationary pressure plus a Fed doing something like yield curve management to keep asset prices pumped up is more of a left-tail risk that is hard to quantitatively analyze, but (to my gut at least) seems unlikely.
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watchnerd
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Re: De-risking, inflation and forward risk tolerance

Post by watchnerd »

cheezit wrote: Wed Apr 07, 2021 10:22 am
That seems fair. The nightmare scenario where there is high inflationary pressure plus a Fed doing something like yield curve management to keep asset prices pumped up is more of a left-tail risk that is hard to quantitatively analyze, but (to my gut at least) seems unlikely.
If we have high inflation again in the intermediate term (10+ years from now), I think it will look different than from the 1970s, because the economy is very different now.

In their TIPS/commodities paper, Vanguard questions whether betting on hard assets / commodities will work as it did in the past, given the service economy of today.
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JBTX
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Re: De-risking, inflation and forward risk tolerance

Post by JBTX »

For one, everybody is worried about inflation. So it is kind of baked in.

Two, while we can't predict the future, my best guess is we will experience a modest uptick in CPI, 2-5%. It isn't catastrophic but also non trivial.

There will be pockets that experience higher than cpi, and inflation may seem higher.

Stocks will probably do OK or maybe even well in such an environment, but that's hard to determine. If inflation gets to the higher end of that range it could spook the bond market and push long term rates up, which often (but not always) is not good for the stock market.

Homes tend to do well in such an environment, at least until interest rates catch up, then it is more mixed.

Hard assets like gold, silver, etc may do OK, but that is a crap shoot.

REITS, value and small cap value tend to do better, but again no guarantees.

International could make sense if the inflation leads to relative devaluation of the dollar.

Ibonds are a good safety vehicle for taxable funds and liquidity reserves. TIPS give some protection in tax advantaged accounts but they are priced terribly and pretty much guaranteed to lose real value.

I totally agree don't pay down a low interest mortgage.
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dual
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Re: De-risking, inflation and forward risk tolerance

Post by dual »

Oicuryy wrote: Wed Apr 07, 2021 12:16 am
Independent George wrote: Tue Apr 06, 2021 5:39 pm Since inflation is itself a direct threat to the cash reserve,
What makes you say that? Cash in the bank held its own against inflation in the 1970s.

Image
https://fred.stlouisfed.org/graph/?g=CVSH

Ron
These graphs are before tax. For most Bogleheads, income taxes reduce the Tbill returns by 25-30% and closer to 40% for interest from CDs in high tax states like California.
Last edited by dual on Wed Apr 07, 2021 10:44 pm, edited 1 time in total.
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Re: De-risking, inflation and forward risk tolerance

Post by dual »

A problem with Treasury inflation indexed securities like TIPS and Ibonds is that the CPI figure they use most likely does not match your personal rate. Plus the interest and inflation adjustment are Federally taxable. See this table making the rounds on the internet. I think the numbers are the annual increase in price but the source is not given. They seem to reflect similar numbers I have read

Steel +145%
Lumber +126%
Oil +80%
Soybeans +71%
Corn +69%
Copper +50%
Silver +38%
Cotton +35%
Coffee +34%
Wheat +25%
FAO Food Index +25%
Cattle +21%
Bitcoin +470%
Stock Market +23%
Home Values + 8%
Hourly Wages +5%
Money Supply Up +24%

Reported Inflation +1%
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dual
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Re: De-risking, inflation and forward risk tolerance

Post by dual »

learntoinvest123 wrote: Tue Apr 06, 2021 7:57 pm I currently have zero gold exposure.
...
By letting inflation run hot, the Fed is giving hard asset investors free money by punishing fixed income investors. We should be fully invested in those.
I like your suggestions but these seem contradictory. Please explain.
DB2
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Re: De-risking, inflation and forward risk tolerance

Post by DB2 »

dual wrote: Wed Apr 07, 2021 1:04 pm A problem with Treasury inflation indexed securities like TIPS and Ibonds is that the CPI figure they use most likely does not match your personal rate. Plus the interest and inflation adjustment are Federally taxable. See this table making the rounds on the internet. I think the numbers are the annual increase in price but the source is not given. They seem to reflect similar numbers I have read

Steel +145%
Lumber +126%
Oil +80%
Soybeans +71%
Corn +69%
Copper +50%
Silver +38%
Cotton +35%
Coffee +34%
Wheat +25%
FAO Food Index +25%
Cattle +21%
Bitcoin +470%
Stock Market +23%
Home Values + 8%
Hourly Wages +5%
Money Supply Up +24%

Reported Inflation +1%
Let's also look at health care and college costs. Likely to be well above 1%.
alluringreality
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Re: De-risking, inflation and forward risk tolerance

Post by alluringreality »

dual wrote: Wed Apr 07, 2021 1:04 pm See this table making the rounds on the internet. I think the numbers are the annual increase in price but the source is not given.
Aside from someone that wants to play an angle, why would anyone use a June to March timeline?
https://twitter.com/redditinvestors/sta ... 6312994820
Last edited by alluringreality on Wed Apr 07, 2021 1:31 pm, edited 2 times in total.
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dual
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Re: De-risking, inflation and forward risk tolerance

Post by dual »

alluringreality wrote: Wed Apr 07, 2021 1:22 pm
dual wrote: Wed Apr 07, 2021 1:04 pm See this table making the rounds on the internet. I think the numbers are the annual increase in price but the source is not given.
Aside from someone that wants to play an angle, why would anyone use a June to March timeline?
https://twitter.com/redditinvestors/sta ... 6312994820
perhaps to avoid distortions due to the March-April flash crash?
If anyone actually cares, soybean prices look like they're currently around 2012 prices according to the following.
https://www.agweek.com/business/agricul ... g-interest
Do you dispute the price increases of the other items in the table?
Last edited by dual on Wed Apr 07, 2021 1:32 pm, edited 1 time in total.
alluringreality
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Re: De-risking, inflation and forward risk tolerance

Post by alluringreality »

dual wrote: Wed Apr 07, 2021 1:25 pm perhaps to avoid (some) distortions due to the March-April 2020 flash crash?
According to the first result from Google, June was nearly the lowest price for soybeans 2012-2021. Another way to look at it is that current soybean prices are similar to 2012. I looked at historical wheat prices and the FAO Food Price Index information. I would tend to suggest that both generally suggest returning to previous prices, rather than setting new highs.
https://www.agweek.com/business/agricul ... g-interest
http://www.fao.org/worldfoodsituation/f ... sindex/en/
Last edited by alluringreality on Wed Apr 07, 2021 2:39 pm, edited 1 time in total.
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Robot Monster
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Re: De-risking, inflation and forward risk tolerance

Post by Robot Monster »

cheezit wrote: Wed Apr 07, 2021 10:22 am ...The nightmare scenario where...Fed [does] something like yield curve...
Yes, I worry about the Fed suppressing interest rates all along the curve in the face of higher inflation. I own TIPS because of this possibility.

There is a Wall Street Journal, "Is Inflation a Risk? Not Now, but Some See Danger Ahead" link The article talks about how the Fed is super-duper dovish. "'The focus on inequality drives this maximum-employment mandate, and it really takes precedence over the inflation mandate,' said Ellen Zentner, chief U.S. economist at Morgan Stanley." The Fed has not even made clear "what level of inflation would be too high. In January, Charles Evans, president of the Federal Reserve Bank of Chicago, said: 'I’m not worried about inflation going up substantially beyond 2.5%. I don’t even fear 3%.'" Also mentions the possibility of political pressures to keep rates low, or even change the inflation target, mentioning a suggestion to go as high as 4%.

I have two additional sources that suggested it would be a good idea if the Fed raised its target to as far as 4%.

"Raising the long-term inflation target from the current 2% to a still-modest 4% would substantially increase the rate at which debt effectively vanishes." link

"One alternative to the Fed’s current approach would be to keep targeting the inflation rate, but to raise the target from the current 2 percent, perhaps to 3 percent or 4 percent." link

You may wonder, can the Fed really do this? Isn't their 2 percent target engraved in stone? It is not. "In 1996, Fed policymakers privately agreed that their target for inflation was 2 percent, but, at Greenspan’s insistence, they didn’t tell anyone. In 2012, at the urging of then-Chair Ben Bernanke, the Fed formally and publicly announced that they were targeting a 2 percent inflation rate." (same source as prior link)
"I think we may see a return to full employment next year." -- Janet Yellen, March 23rd 2021
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