Have you noticed how investors -- if not President Trump -- have largely shrugged off recent interest rate hikes?At its latest meeting in June, the U.S. Federal Reserve, as expected, hiked its benchmark short-term rate by a quarter point, to a range of 1.75% to 2%. It was the second quarter-point rate increase this year.
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And the markets barely budged. No, scratch that: the markets have moved decisively higher. Large-cap stocks, represented by the S&P 500 index, are up more than 5% year-to-date. The Dow Jones Industrial Average, a blue-chip index, is up 2% year-to-date, having recovered the losses it suffered early in the year. And the tech-heavy Nasdaq has beaten them all, up 13% and counting. The interest-rate sensitive utilities (as represented by the Dow Utility Average) -- although still slightly down, if you don't count dividends, year-to-date -- have rallied some 9% off their June lows.
The question at this time, however, is whether the economy -- and the market -- will be able to handle at least five more. Yes, five.
That's because the Fed is expected to continue on the rate-rising path this year, raising the benchmark rate two more times, followed by an expected three more hikes next year.
While the market action, by itself, does not indicate any trouble on the immediate horizon, several issues that could derail this rally have emerged, and the Fed tightening is only one of them.
We don't know, of course, whether the trade wars will continue and what the ultimate impact on the economy will be. What we do know today is that Fed officials, in recent speeches, have stressed the dangers of tariffs and their potentially destructive economic impact.
For instance, at the July 17 hearing before the Senate Banking Committee, Fed chairman Jerome Powell testified to the ongoing strength of the economy. Such a scenario would justify further rate increases. On the other hand, he has also indicated the Fed would put expected rate increases on hold if higher tariffs and ongoing trade wars bring about an economic slowdown.
Monetary policies are a powerful tool. Thanks largely to near-zero interest rate policies and large-scale purchases of assets by central banks here and abroad, the leading economies were able to exit the Great Recession of 2008-2009 and return to growth.
But if a tool works in one direction, does it always work in the other direction?
With the ongoing interest-rate hikes, the U.S. Fed is, generally speaking, applying the brakes to a strong economy. If and when it senses a slow-down, it should be able to reverse course in time to once again spur growth, right?
Needless to say, this is not an exact science. And neither is it always a helpful one for investors. For one thing, monetary policies work with a lag. For another, the Fed's stated goals -- maximum sustainable employment, stable prices, and moderate long-term interest rates -- don't have a strong stock market among them.
All of which raises the possibility that the Fed won't always be doing the right thing at any given time.
Generally speaking, the Fed could make two major policy mistakes: it can overtighten (slowing the economy too much) or under-tighten (allowing inflation to become an issue). Thus, despite the relatively benign Fed-related headlines of late, investors should be ready to employ some defense.
My latest pick for The Daily Paycheck is dedicated to just that. I discussed two possible hedges that might help a portfolio if the Fed makes a mistake.
With this stock market taking everything that's thrown at it in stride, at least so far, I'm not yet ready to employ either of these hedges. But it's always good to be prepared.
But with this bull market getting long in the tooth, many investors, especially those with shorter investment horizons, increasingly question whether the gains will hold and when they should take actions to protect those gains.
While nobody can convincingly answer this question or determine exactly when and why the markets turn, there are certain steps investors can take to stay protected -- just in case.
How To Hedge Against Inflation
If the Fed fails to keep up with its interest rate increases and the economy overheats, many investors would benefit from an inflation hedge, such as Treasury Inflation-Protected Securities, or TIPS. TIPS are U.S. treasuries designed to keep up with inflation.
There is a downside to TIPS, too. First, the yields are tied to the yields of regular Treasuries and, therefore, are now quite low. Further, because of the way TIPS address inflation -- via adjusting the principal semiannually based on the consumer price index (CPI) -- their ability to compensate for inflation depends on whether or not the CPI reflects the true extent of it. And, finally, because they are bonds, TIPS are poised to be hurt as interest rates increase (although interest rates typically correlate with inflation).
While not perfect, TIPS are one of the few fixed-income investments that offer leverage to inflation. And it's easy to invest in TIPS via exchange-traded funds (ETFs).
My favorite TIPS-related ETF is quite cheap. With an expense ratio as low as 0.05%, investors get more kick on their invested buck in terms of income than from the larger and better-known iShares TIPS ETF (NYSE: TIP), with its 0.2% expense ratio.
The fund, Schwab US TIPS ETF (NYSE: SCHP), has $5.6 billion under management, which means it's quite liquid. And because the yield on TIPS is related to the yield on Treasuries, SCHP also generates a decent-enough yield of about 2.4% (on a trailing basis).
SCHP is a good fund to have in your investment arsenal. Let's keep it on our watch list.
TIPS are a good inflation hedge. But during the Great Depression, and for years after, the main concern was deflation, not inflation.
Deflation, or declining prices, is another economic phenomenon that's bad for stocks. Deflation hedges, therefore, often can protect against market declines.
One such deflation hedge to keep on your watch list is zero-coupon bonds. In the Treasury market, zeros are represented by Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities). STRIPS means that a bond is stripped of its coupons, and each begins to trade separately. The resulting bond -- a zero-coupon bond -- sells at a large discount to its face value, but at maturity, the entire principal value of the bond is repaid.
Zeros are bonds, and, just like for any bond, their price moves in the opposite direction of interest rates. But because they are stripped of the coupon, the market price of zeros falls -- and increases -- more, all else equal, then the price of conventional coupon-bearing bonds.
Because of this huge leverage, the price of zero-coupon bonds will increase sharply if interest rates fall. This makes them a deflation hedge. This also makes them a good hedge against a stock market decline. If excessive tightening by the Fed were to endanger the economy -- or even if investors begin to price in such an event -- the stock market might turn south. In this case, as it has typically been, investors would want to hide in long-term Treasury bonds, benefiting zeros even more.
My preferred fund here is Vanguard Extended Duration Treasury ETF (NYSE: EDV), which owns a basket of long-term, zero-coupon bonds. It's better-known, larger, and, most important, cheaper than its competitor PIMCO 25+ Year Zero Coupon U.S. Treasury Index Exchange-Traded Fund (NYSE: ZROZ). Both are poised to rally if deflation hits and the stock market falls. But EDV is cheaper, at only 0.07% expense ratio, compared with ZROZ's 0.15%, and so it's the one that makes the cut.
At some point, we might need to run to one of these shelters. But I'm not ready to do that yet. Still, we need to be prepared for either of these possible scenarios -- they could easily wipe out hard-won gains in your portfolio. Of course, I will alert my Daily Paycheck readers first if and when that need arises.
By staying on top of the market and thinking ahead, my Daily Paycheck subscribers and I are no longer anxious about retirement. Our portfolio generates more and more income every month, allowing our followers to either keep growing their income -- or flick the switch and start living a worry-free retirement.
You don't have to be anxious, either. Overall, the portfolio has been roughly 37% less volatile than the overall market. That represents 37% more sleep-filled nights for subscribers.
This article originally appeared on StreetAuthority.com.