Post FOMC October 2019 Thoughts
This week’s 25 basis point cut in the fed funds rate to a new range of 1.5% - 1.75% did not surprise the markets, with bonds revealing a strong bid at the conclusion of the FOMC meeting. Focus was placed upon changes to the policy statement language as well as on every word spoken by Chair Powell during the post-session press conference. So now the question before market participants has become, will further accommodation be required or will the aggregate 75 basis point rate cut be sufficient to bolster growth, minimize risks to the economic outlook, and lift inflation to sustainably meet the Central Bank’s 2% target? Before we wave goodbye to 2019, policymakers will have their final meeting in December and we believe that the Fed is now telegraphing a pause to its “mid-cycle adjustment”. The just released October labor report would seem to embrace this sentiment with a larger-than-expected print in the headline payrolls number and upward revisions for the prior two months.
Perhaps most conspicuously absent from the new statement is the language from previous statements indicating that the Fed will “act as appropriate to sustain the expansion”. Of course, the Central Bank wants to see an extended recovery, but we view the removal of this wording as an indication that it likely believes that sufficient stimulus has been injected into the economy at this time. If Chair Powell and team are truly committed to extending the recovery for as long as possible, consideration must be given to the noted mark downs of domestic growth forecasts. However, we believe that the current U.S. economic profile supports a less dovish posture and we would not favor further easing. Chair Powell has indicated that a return to tighter policy would require outsized inflation growth, a characterization that has thus far remained elusive.
Certainly, trade and geopolitical disruption will consume much of the policy narrative given that these evolving concerns have been at the heart of this temporary easing cycle, yet we do think that the current funds range takes account of these growth headwinds. There may be a signed trade deal as early as next month, but for this to happen both the U.S. and China would need to follow good faith negotiations as well as to acknowledge the value of political necessity. Although the U.S. delegation has firmly been pressing the Chinese government to address a list of historically criticized, yet unresolved unfair trade practices, the Trump administration may have to accept something less than what has been outlined in “phase one” of the trade accord if President Xi Jinping and his government decide to walk back the earlier agreement.
We have to believe that a new layer of tariffs upon Chinese exports into the U.S. scheduled to take hold in December could be used as a bargaining chip by either side as the process moves forward. Although we do believe that a deal of sorts gets done over the near-term, the ability to monitor compliance with its terms will likely be a challenge and so we wonder what types of remedial triggers would be part of the agreement. Although we offer a modest risk of recession over the near-term, we continue to view a slowing global economy against an uncertain trade and Brexit backdrop as a meaningful risk determinant that could bring the longest running U.S. recovery to an abrupt conclusion. Furthermore, there are no guarantees that the global Central bankers, including our very own Fed, can successfully engineer a soft landing – although kudos to the Fed for closely parsing the economic data points and for credibly managing market expectations. We maintain that any renewed business investment must be preceded by more convincing and substantial trade certainty, and this means that updates on trade negotiations are simply not enough. As for the consumer, the Fed will be watching for any signs of tepid activity that could place downward pressure upon GDP.
As we navigate the fourth quarter of 2019, we do so with a great deal of trepidation given the seemingly endless number of potentially influential variables that could drive market performance. For now, we are confident that demand for tax-exemption should support muni performance through the remaining months of the year, and when we refer to performance, this could mean that ongoing demand may temper the losses brought about from heavier issuance patterns. Nevertheless, sentiment has taken on multi-dimensional significance and we expect this dynamic to closely influence the risk-on/risk-off trade as volatility continues to shape the investment narrative. We would further posture that evolving geopolitical circumstances may elevate the allure of haven assets, with municipal bonds as a clear beneficiary enjoying a strong bid. While we are not necessarily supportive of further Fed easing, we do think that rates have the potential to move lower with or without additional cuts. Slowing economic momentum with benign inflationary pressure and geopolitical events support this thesis and we think that issuers will continue to have attractive entry points throughout Q4. The lower-for-longer rate environment, coupled with muni-market-specific conditions, has elevated taxable advance refunding issuance to the point where October primary market supply exceeded $50 billion.
We expect bond yields throughout the final quarter to move in response to trade developments, and just how munis perform relative to UST will be largely determined by technical factors and we will be particularly following fund flows as a reliable barometer of demand. We have just recently witnessed the 43rd consecutive week of inflows.
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