Scary and scarier: rising prices and rising rates

Data expected out of Washington this week may raise anxiety levels of investors and consumers who are already worried about inflation and rising interest rates.

On April 12, the Bureau of Labor Statistics reported that U.S. import prices jumped in March. Well also get data on producer prices on April 14 and consumer prices on April 15. But heres what we already know: It costs more to fill your car, and your belly. And what doesnt run on food or fuel?

At the same time, Federal Reserve officials have gone out of their way to pooh-pooh the dangers of inflation. That just worries consumers and bond investors all the more. If niche commodity price increases start feeding through to other goods and services, or if the Fed starts throwing around too much cash, the end result could be rising long-term interest rates. And rising rates could slam bond investors, who would lose money if the prices of their bonds fell to create higher yields. That would be particularly bad for mom and pop retirement investors who have been told that bonds are safer than stocks.

So, what to do, what to do? Realize, first, that rising prices and rising long-term bond yields are two distinct and different situations. Even though in theory, they should be linked together, the math shows they dont move in lockstep, says Tim Courtney of Burns Advisory Group in Oklahoma City. Long-term bond yields are more likely to rise ahead of consumer inflation. Theyll rise when bond fund investors start to expect future inflation.

That means investors and consumers should be planning for both eventualities separately. Here are five ways to protect yourself from rising rates. (Well address rising prices in a later post.)

Be careful about TIPs. Treasury inflation-protected securities promise to protect portfolios from the ravages of inflation, through a complex pricing mechanism. Their yield is divided into two parts: a fixed yield and a yield guaranteed to rise with the Consumer Price Index. Right now, they are more expensive than regular Treasuries an expectation of two percent annual inflation is built into their price, says Courtney. That means they will only pay off if inflation runs higher than that, but that isnt the real risk with these bonds. The real risk is that interest rates will rise, but prices wont. Then what happens to TIPs holders? Theyll get slammed. Their yields wont rise and their prices could fall.

Short bonds. This is something Pimcos bond buff, Bill Gross, has already started to do. His Total Return Fund the world largest bond fund began shorting Treasury debt in March. Ed Easterling, president of Crestmont Research, an investment research firm, suggests that this is one of the very few ways you could buy proactive protection from future inflation. If rates go up in anticipation of future inflation, and youre shorting long bonds (in effect, borrowing bonds and selling them at todays prices), youll gain when bond prices fall and you can cover your short position with cheaper bonds. That sounds complex, but you could do that by buying shares of an exchange-traded fund, such as the Proshares Ultra Short 20 Yr Treasury. that inverts and doubles the performance of long term Treasury bonds. Even more aggressive, reports Lipper, is the Direxion Daily 20+ Year Treasury Bear 3x exchange-traded fund. That inverts the Treasury 20-year bond and then triples it.

Buy foreign bond funds that dont hedge the dollar. That could work if either higher interest rates or higher prices hit. Foreign bonds tend to pay higher interest than U.S. bonds. Furthermore, if you buy them with todays dollars and then prices rise, cheapening the value of the dollar, youll win again when you trade your foreign-denominated shares back into dollars.

Dont be overly impressed with commodities. In the first place, you may have already missed the big gold rush. In the second place, commodities dont typically beat inflation, they just match it, says Courtney. We dont have commodities in our portfolio because the expected return of all of them together is just equal to inflation. And thats just not good enough for a hedge, he contends.

Dont go crazy. Of course, its entirely possible that both prices and interest rates will remain under control, or even ratchet back down. So you wouldnt want to devote your entire portfolio to positioning yourself for a price and rate blowout. Instead, keep the bulk of your portfolio on track, and reserve a slice for inflation and interest rate fighting. Then go worry about something else.