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How Real and How Imminent Is the Inflation Threat?

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As the price of crude oil rises due to violent civil unrest in Libya and the Middle East, the risks are rising that inflation will become a concern for our central bankers and the financial markets.

Investors, if they’re worried about an inflationary future, can engineer an inflation-centric portfolio, a strategy we detailed a recent article. Economist and strategists urge such market participants to own commodities, gold, companies with low debt-to-equity ratios, and perhaps Treasury Inflation-Protected Securities (TIPS), which are government-backed bonds that provide protection against rising prices.

But just how worried should you really be about some broad inflationary breakout?

James Stack of InvesTech Research argues that, based on food, energy, and commodity prices, the developing inflation threat would appear quite real, in his opinion, but not necessarily imminent -- at least not yet.

Digging into the inflation data, Stack says that some components still remain tame, but others are obviously heating up. Specifically, housing inflation is now at the lowest level in 40 years. But food inflation, after bottoming in 2009, is now moving higher. As for energy inflation, oil prices are over 30% below their 2008 peak but, as Stack notes, a price of $100 per barrel couldn’t really be called cheap.

Outside of food and energy, raw industrial commodity prices have jumped sharply from their 2008 lows:

As for investment implications, the strategist cautions investors to remember that inflation doesn’t cause a bear markets, but rather it’s the resulting rise in interest rates that typically does. And, while there might be little chance that Ben Bernanke and his allies on the FOMC raise interest rates, there is the possibility that long-term bondholders -- or the so-called “bond vigilantes” -- will start to demand higher yields to compensate for increasing inflation risk, just as they did in the 1980s and 1990s.

Historically, there is no better “bond vigilante” signal than the yield on the long bond. Since late August, when Bernanke first opened the door to another round of bond buying, 30-year bond yields have pushed up toward 5%, which as Stack emphasizes could have implications for both the economic recovery and equity markets if rates keep rising.

Bottom line, says Stack: There are many times in past economic cycles when inflation pressures start to build and then cool off. But prudent investors will keep an eye on the “bond vigilantes” in the months ahead to see if this posse mounts up.
POSITION:  No positions in stocks mentioned.