January Inflation Report: A Glimmer Of Hope For TIPS And I Bonds?

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Includes: TIP
by: Tipswatch

Summary

Headline inflation was unchanged in January, but up 1.4% over the last 12 months.

Energy prices fell sharply a year ago, so they now have a less dramatic effect on inflation.

I Bonds are heading toward a possible six months of 0.0% interest rates.

The Consumer Price Index for All Urban Consumers (CPI-U) was unchanged in January on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, 'headline' inflation increased 1.4%.

It was an interesting report, with overall energy prices down 2.8% for the month and gasoline down 4.8%. However, these energy numbers are now comparing to much lower numbers from 2015. Gasoline prices have fallen only 7.3% over the last 12 months. Compare that to December's inflation report, when gasoline was down a whopping 19.7% from December 2014.

Heading into 2016, energy prices - as low as they are - are going to have a lesser effect on overall inflation, because the strong trend downward began in January 2015. If energy prices begin rising, headline inflation is going to take a jump.

'Core inflation' - which strips out food and energy - increased 0.3% in January and 2.2% over the last 12 months. The BLS says this is the highest 12-month change since June 2012, and exceeds the 1.9% average annualized increase over the last 10 years. And it is actually above the Federal Reserve's target of 2% inflation, although the Fed tracks a different index.

Effect on inflation-adjusted investments

Holders of Treasury Inflation-Protected Securities and I Bonds are also interested in non-seasonally adjusted inflation, which is used to adjust the principal balance of I Bonds and set future interest rates for I Bonds.

Non-seasonally adjusted inflation rose 0.17% in January, reaching an inflation index of 236.916. This broke a string of five consecutive deflationary months. The rise gives some relief to TIPS holders who will see principal balances increase in March.

However, holders of I Bonds are looking at an ugly scenario: A negative inflation-adjusted rate at the next reset on May 1. I Bonds have a composite rate set by the combination of a fixed rate which holds through the life of the I Bond, and the inflation-adjusted rate, which resets very May and November.

The May adjustment is determined by inflation from September 2015 to March 2016. At this point, with two months remaining in the period, non-seasonally adjusted inflation has been running at -0.43%.

Unless inflation rises in February and March, I Bonds are going to get a negative inflation-adjusted rate. Although the composite rate can't fall below 0.0%, a negative inflation-adjusted rate can wipe out the fixed rate.

In other words, a lot of I Bonds - especially those purchased in recent years with fixed rates of 0.2% or less - could be paying 0.0% for a six-month period. (The variable rate goes into effect based on the month that you originally bought the I Bond, but eventually affects all I Bonds.)

This happened in 2015, when the inflation-adjusted rate dropped to -0.80%, or -1.60% annualized. That wiped out any fixed rate of 1.6% or less. This year shouldn't be as severe, especially if non-seasonally adjusted inflation rises over the next two months.

Advice: Do nothing, for now

If you were considering buying I Bonds in 2016, hold off. You definitely don't want to buy just before six months of zero interest rates. Wait at least until the March inflation report comes out on April 14, and you will then know the variable rate for the May to October period.

I also wouldn't be in a rush to sell I Bonds, especially those with inflation-adjusted rates of 0.7% or higher (those all date back to 2007 and before).

If you decide to sell, target I Bonds paying the lowest fixed rate. You can sell any I Bond you have owned for a year (with a three-month interest penalty if you sell before five years). If you wait three months of 0.0% interest, you can sell with no penalty at all.

If inflation does make a turnaround, you're likely to see a much higher composite rate in November. For example, in the May 2009 period, the variable rate fell to -5.56% (in effect setting the composite rate to 0.0% - it can't go below zero). Then it bounced back in November 2009 to 3.06%.

Waiting out the zero composite rate paid off in 2009. It could pay off again in 2016.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.