Measuring The Inflation Risk Of Three ‘Inflation-Hedges’

Measuring the Inflation Risk of Three ‘Inflation-Hedges’

By Doris Bao, FRM and Alex Botte, CFA, CAIA, Client Solutions Research team at Two Sigma

In our previous post on inflation, we covered how the Local Inflation risk factor in Venn, Two Sigma’s risk analytics platform, is constructed and we reviewed its historical performance. The primary conclusion was that the factor is designed to capture exposure to a local-currency inflation hedge that benefits a portfolio or investment when inflation surprises to the upside, but otherwise loses money due to being short the inflation risk premium embedded in nominal bonds. To put it in another way, this factor is like buying an “insurance policy” against inflation. You pay a premium (the inflation risk premium), but if inflation is higher than expected, the “policy” pays off for you.

Now that we understand the factor’s construction and the theory behind it, in this post, we will analyze three assets that are commonly used by investors as inflation hedges: gold, a TIPS fund, and natural resource equities. We will use Venn’s returns-based regression analysis to understand each asset’s risk exposures, including their sensitivity to inflation hedging risk as proxied by our Local Inflation factor.

  1. Gold
    Gold is widely considered a classic inflation hedge. As mentioned in What Is the Ultimate Safe-Haven Investment?,” in the case of hyperinflation, paper money like the USD is in greater danger of losing value than claims on hard assets like gold.

As shown in Exhibits 1 and 2, gold has four main factor exposures (all positive) that drive ~50% of gold’s risk: Interest Rates, Commodities, Foreign Currency, and Local Inflation. The exposure to Commodities is somewhat obvious and expected, so we will spend some time digging into gold’s three other factor exposures.

Exhibit 1: Factor Exposures of Gold 

Sources: Venn and Commodity Systems Inc. (CSI). Time period: August 1, 2015 – July 31, 2020, using daily returns.


Exhibit 2: Factor Contributions to Risk of Gold

Sources: Venn and CSI., Time period: August 1, 2015 – July 31, 2020, using daily data.

First, gold’s exposure to Interest Rates reflects the fact that gold is positively correlated with nominal government bonds globally. This is expected as we mentioned in “Five “Safe-Haven” Assets and Their Performance During the COVID Market Crisis,” bonds and gold are both perceived as safe haven assets. Sometimes gold may even be viewed as a more attractive portfolio diversifier than Treasuries when yields drop (and bond prices rise).

Second, gold’s exposure to the Foreign Currency factor (which is long G10 ex USD currencies funded by a short USD position) highlights that gold has been moving in the opposite direction to the USD. This relationship is also demonstrated by gold’s negative correlation with the U.S. Dollar Index shown below. One major driver 1 of this negative relationship is that gold is denominated in USD, so when USD depreciates relative to other currencies, investors in those countries can buy more gold with the same amount of their local currencies. Thus, demand for gold increases, which then drives up gold prices in USD.

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Harry Goldstein 1 month ago Member's comment

Thanks for the read.