Treasury Inflation-Protected Securities

By David Enna, Tipswatch.com

You can’t watch CNBC for more than 10 minutes without hearing some analyst predict the Federal Reserve will begin cutting interest rates in March 2024 … or May … or certainly by June.

On the other hand, Fed officials have rigorously maintained that interest rates — while possibly not increasing again — will remain at current levels well into next year. This is what Fed Chair Jerome Powell said on December 1:

The FOMC is strongly committed to bringing inflation down to 2 percent over time, and to keeping policy restrictive until we are confident that inflation is on a path to that objective.

It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so.

Then we got Friday’s jobs report, with employers adding 199,000 jobs last month, considered a sign the U.S. economy is not faltering. The unemployment rate fell to 3.7%, down from October’s 3.9%. Average hourly earnings were up 4% year-over-year, exceeding the current inflation rate of 3.2%.

My conclusion: 1) The Fed doesn’t need to raise short-term interest rates, and 2) The Fed doesn’t need to cut short-term interest rates, at least until data begin showing a slowing U.S. economy.

But the bond and stock markets don’t seem to agree, thanks to a short-term focus. Bond yields have been falling for the last 45 days. The S&P 500 is up 5.25% over the last month. Highly speculative investments like Bitcoin have been surging higher. Here is a “moderate” view from Dryden Pence, chief investment officer at Pence Capital Management, predicting just a “couple” rate cuts next year:

In this video, CNBC’s Mike Santoli attempts to debunk the idea that the surge in higher-risk assets has been caused by predictions of a Fed pivot. “To me, the stock market right now is not at this level because we are assuming we will get 100 to 150 basis points of cuts next year,” he says. “It’s because … we have a little more of a sustainable moment in the expansion.”

Nice theory, but if this were true, you’d see mid- to longer-term bond yields sustaining at high levels. Instead, they have been declining sharply. Expectations of lower interest rates are driving this market.

Next week’s inflation report, coming Tuesday at 8:30 a.m. ET, will probably give another boost to market optimism. The forecast for November all-items inflation is 0.0%, which should inch the annual rate closer to 3.0%. Core inflation, however, is expected to remain steady at 4% year over year.

Real yields are declining

We’ve just had a “Goldilocks” period of above-inflation yields nearing 2.5% across all maturities, beginning Sept. 19 and lasting until early October. But that ended last week, with both the 10-year and 20-year real yields dipping below 2.0% for two days, before bouncing back on Friday in the wake of the positive jobs report.

Investors looking to build a solid ladder of TIPS investments, stretching well into their retirement years, had a nice opportunity to fill that ladder, or add to it. I think we will probably see lower yields heading into 2024, but nothing is certain.

Remember, real yields holding around 2% remain attractive. That yield is likely to cover any taxes owed, meaning your investment will at least match, or more likely easily exceed, future inflation, even after taxes. For perspective, here is a chart showing 5-, 10- and 30-year real yields since January 2020, just before the massive pandemic-triggered Federal Reserve easing beginning in March 2020:

This is a strange-looking chart because the yield curve is now close to perfectly flat. For the future, I expect a wider spread, and that will probably mean the shorter-term yields will fall and longer-terms will rise, or at least not fall as far.

This weekend, a Barron’s commentary backs me up:

The better question is where rates will settle in the coming decade. The probable answer: below today’s target range of 5.25%-5.50%, but higher than many economists and policy makers expected a year or two ago, and far higher than the near-zero rates of the past 15 years.

And then there is the fact that budget deficits are going to soar well into the future, forcing ever-higher Treasury borrowing. From Barron’s, a rather scary projection:

What this means for I Bonds

If real yields continue falling, the I Bond’s current fixed rate of 1.3% is going to look more and more attractive. Since Nov. 1, both the the 5-year and 10-year TIPS yields have averaged about 2.2%, which at this point would equate (possibly) to an I Bond fixed rate of about 1.3% to 1.4%. But if real yields continue falling, we very well could see a lower I Bond fixed rate at the May 1 reset. And that could be combined with a lower variable rate if inflation continues sliding lower.

The great thing about I Bonds is that the 1.3% fixed rate is available for purchases through the end of April 2024. Investors who purchase any time before then can lock in the 1.3% fixed rate for the life of the I Bond, plus a composite rate of 5.27% for a full six months.

Several readers have mentioned recently that they are considering over-paying 2023 estimated taxes to get $5,000 in paper I Bonds in lieu of next year’s federal tax refund. Not a bad idea, if you like this strategy.

At this point in time, for an experienced investor, TIPS yielding 2% above inflation remain more attractive than an I Bond with a fixed rate of 1.3%. But the gap is narrowing, and I Bonds have many advantages over TIPS: flexible maturity, better deflation protection and deferred federal taxes.

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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. I Bonds and TIPS are not “get rich” investments; they are best used for capital preservation and inflation protection. They can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.