By David Enna, Tipswatch.com
The year 2022 broke through several economic milestones, and most of them were dreadful: Highest U.S. inflation in 40 years. U.S. stock market down 20%. U.S. bond market down 13%. Federal Reserve aggressively raising interest rates. War in Europe sending gas prices soaring at mid-year. Pandemic causing supply shortages. Mortgage rates nearly doubling.
But there was a bright side: The Federal Reserve actually stuck to its plan to fight inflation despite possible damage to the U.S. economy. (I was surprised.) And interest rates — especially short-term rates — rose to attractive levels, finally giving investors a chance to build a safe, worthwhile cash holding.
Real yields on Treasury Inflation-Protected Securities also rose to attractive levels, the highest in 15 years. And U.S. Series I Savings Bonds became the surprising star of mainstream financial news.
It was easy to see this surge in inflation coming, after years of easy money from the Federal Reserve and massive stimulus payments from Congress. The Fed argued inflation was “transitory.” It wasn’t.
U.S. inflation ended 2021 at 7.0%, the highest annual rate in 40 years. And things got much worse early in 2022, with inflation rising at an annual rate of 12.2% in the six months from January to June, before moderating in the last months of the year. Year-over-year inflation peaked at 9.1% in June 2022, the largest 12-month increase since November 1981.
But since June, inflation has been slipping lower along with falling gas prices, dropping to an annual rate of 7.1% in November. Here is the year-over-year trend in U.S. inflation in the last 12 months, showing the gradual decline in all-items inflation, even as core inflation has remained stubbornly around 6%:
What’s ahead for inflation? It’s impossible to predict, but my gut feeling is that month-to-month and annual inflation will continue to moderate. One reason: Last year’s monthly inflation numbers were very high from December 2021 to June 2022, as shown in this chart:
Even if inflation runs at 0.4% to 0.5% each month through mid-2023, annual inflation will be declining because of the higher year-ago numbers. So could inflation drift toward an annual rate of 4% to 5% in 2023? It looks likely, as long as gasoline prices hold steady. But as I always note: It’s impossible to predict the future. And annual inflation of 4.8% would remain unacceptable in the long term.
U.S. Series I Savings Bonds were already a mainstream hit late in 2021, after the annualized composite rate rose to 7.12% on November 1, 2021. And then inflation surged even higher, pushing the next rate reset to 9.62% on May 1, 2022. For years, I Bonds had been a fairly esoteric and sleepy niche investment. I remember a day in 2021 when CNBC’s Becky Quick asked her co-hosts: “What is an I Bond? I’ve never heard of it.”
Sleepy, no more. Interest in I Bonds became so intense that buyers crafted strategies to double-, triple-, and even quadruple-dip the $10,000 annual investment limit. In October, the flood of buyers crashed the TreasuryDirect website, crippling it for days. And even with the slowdown, the Treasury sold $979 million of I Bonds in one day, on Oct. 28, the last day to lock in the 9.62% rate for six months.
Then, on Nov. 1, 2022, the Treasury made a very welcome decision. Even though it faced raging demand for I Bonds, it raised the fixed rate for I Bonds purchased from November 2022 to April 2023 to 0.4%, creating a composite rate of 6.89% for six months, still highly attractive. That move demonstrated that the Treasury does pay attention to rising real yields, and acted correctly to raise the I Bond’s fixed rate. This was a move I had been urging. Very glad to see this happen; it’s the first I Bond fixed rate above 0.0% since the November 2019 reset.
Treasury Inflation-Protected Securities
TIPS began the year as an “undesirable investment,” but by mid-year they started getting more and more desirable. The reason can be summed up in this one chart, the trend of TIPS real yields throughout 2022:
Here are the starting and ending real yields for TIPS, based on the market close on Dec. 29:
- 5-year, started the year at -1.53%. Ending the year at 1.62%, an increase of 315 basis points.
- 10-year, started the year at -0.97%. Ending the year at 1.56%, an increase of 253 basis points.
- 30-year, started the year at -0.36%. Ending the year at 1.63%, an increase of 199 basis points.
Obviously, an increase of 250+ basis points of real yield makes TIPS much more attractive today, but holders of TIPS mutual funds and ETFs felt the pain in 2022, even with inflation soaring to a multi-decade high. The TIP ETF has had a total return of about -12% year to date, reflecting its duration of about 6.63 years. The increase in real yields — causing a decline in the value of the underlying TIPS — were enough to wipe out 2022’s inflation accruals.
Investors who buy individual TIPS and hold to maturity can ignore this market volatility, and this was the year when — finally — TIPS became a strong addition to an investor’s “safety” allocation, with real yields surpassing the supremely popular I Bond. Here’s a recap of the year’s TIPS auctions:
CUSIP 91282CDX6: 10-year
The first TIPS auction of the year got a real yield of -0.540%, and its first reopening in March was even worse at -0.589%. This may be the last 10-year TIPS with a coupon rate of 0.125% for awhile. (I hope.)
CUSIP 912810TE8: 30-year
The Treasury stages only two 30-year TIPS auctions a year (and that is plenty, in my opinion.) This TIPS originated in February with a real yield of 0.195% and a coupon rate of 0.125%. By the August reopening the yield was up to 0.92%, and now it trades with a real yield of 1.65% and its price has plummeted to about $64.91, a decline of about 34% in 10 months. Investing in a 30-year TIPS in a rising rate environment is a dangerous idea.
CUSIP 91282CEJ6: 5-year
The first 5-year TIPS auction of the year was in April, just as real yields were starting to inch higher. This TIPS got a real yield of -0.340%, but at least it looked attractive versus the year-earlier 5-year auction, with a real yield of -1.631%. At its only reopening two months later, the yield climbed to 0.362%.
CUSIP 91282CEZ0: 10-year
By July, 10-year real yields had climbed to 0.630%, giving this TIPS a coupon rate of 0.625%, the highest coupon for a new TIPS in three years. By November, the real yield had soared to 1.485%, even as the inflation breakeven rate was declining.
CUSIP 91282CFR7: 5-year
By October, real yields were flying high, leading to the most attractive TIPS auction of the year on Oct. 20. This TIPS got a real yield of 1.732% and a coupon rate of 1.625%, both setting 15-year highs. At the time, the result looked disappointing, but it has held up as a very strong yield. By the December reopening, the real yield had slipped to 1.504%, still attractive.
Importance of inflation protection
I know a lot of investors have been flooding into I Bonds (and more recently, TIPS) as yields have become attractive against a backdrop of harsh inflation. I’m sure many of those investors will eventually move on to the next “hot thing,” and that is fine. But I’ve argued for a decade that it makes sense to keep a certain portfolio allocation dedicated to inflation protection, through I Bonds and individual TIPS held to maturity. Maybe that allocation could be 5%? 10%? 15%?
This incredible and awful year, 2022, has demonstrated the need for inflation protection. That need will still be with us in 2023 and beyond.
Happy new year, everyone.
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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.