Trick Or Treat
- October 25, 2022
As we think about the wild swings across multiple asset classes that have come to define 2022, we cannot help but to equate the highs and lows witnessed by the financial markets with the traditional trick or treat Halloween custom. The catalyst for all of this historic volatility has been the entrenched tug-of-war pitting recessionary fears against the disruptive forces brought on by the highest inflation in forty years. As soon as the financial markets find comfort with any “treat” seemingly sweetened with easing Fed tightening pressure, the “trick” comes in the form of a false sense of security when rates are driven higher by expectations for more restrictive monetary policy. The next FOMC meeting is scheduled for November 1-2. The benchmark 10-year U.S. Treasury yield has landed above 4% - brought to you by September’s CPI print and the barrage of hawkish Fed speak. The Fed has put through 3 consecutive 75 basis point rate hikes and the wager is on number 4 at the early November FOMC meeting, which is all but sealed given the hot CPI for September. With the policy meeting quickly approaching, we find ourselves taking more than just a casual glance at the fed funds futures contracts which not only decisively reflect a 75-basis point rate hike, they have also moved a bit closer to a fifth consecutive 75-basis point boost for the December meeting. We would further point out that while the funds rate had been projected to peak at the end of Q1 2023, the maximum rate is not only trending higher than what was shown just two weeks ago, but the contracts appear to be moving the peak rate out to May of next year (subject to change). Given the policy trajectory, it is reasonable to expect the fed funds rate to be comfortably above 4% by year end and likely close to or at 5% by the conclusion of Q1 2023.
We have made no secret of our position that an argument can be made for a moderation in the Fed’s tightening sequence. Certain key economic data points represent lagging indicators and are therefore viewed through the “rear-view mirror”. Our preference would be for the Fed to allow its out-sized rate hikes to make their way through the system whereby a discernable impact could be measured. We are not necessarily suggesting a pause at this time, but we do think that a rate hike of smaller magnitude may be in order. Monetary policy fatigue has gripped the financial markets to the point where fundamental and technical analysis are difficult to handicap. While consensus among policymakers continues to lead the markets toward more restrictive policy, we are now seeing the “pause” narrative take form and it looks like this becomes more probable should core inflation recede on a consistent basis. We believe that the current tightening cycle has already identified the peak funds rate and that there is no reasonable basis for the futures market to price beyond current expectations. When policymakers meet, there is likely to be ample, and perhaps heated, debate over a policy recalibration and we do expect there to be more support for a pause at some point beyond November. In our view, a December pause is unlikely, but the potential is building for a smaller rate hike, followed up with a pause early in Q1 2023.
We expect retail to remain involved with rates moving potentially higher, but the opportunities may very well come with unforeseen volatility and so appropriate entry points with an understanding of call optionality must be key to the investment calculus
Messaging from the markets is very important and we will be looking for a signal that the Fed is approaching the end of its tightening sequence given that rates are now at a level that are sufficiently above zero, and that could produce real economic consequences while at the same time allowing the Fed to keep some of its monetary powder dry. Of course, the tricky issue is how to adapt a sensible strategy without sending the wrong or incomplete message to the financial markets. Imagine if you will, a time when par or even discounted 5% coupons can be available. This dream has become a reality and retail investors are showing interest in the attractive cash flow opportunities offering equity-like returns. We would continue to urge the retail investor to be mindful of both credit and structure when fashioning a defensive muni portfolio that can demonstrate resiliency and performance during a recessionary cycle. We expect retail to remain involved with rates moving potentially higher, but the opportunities may very well come with unforeseen volatility and so appropriate entry points with an understanding of call optionality must be key to the investment calculus. Our message has been straightforward throughout the Fed’s tightening sequence – tax efficiency, diversification and credit quality attributes, along with historically lower levels of macro market volatility can often make munis a stand-out investment in terms of performance and portfolio resiliency. The yield and income opportunities available today are compelling for muni investors and the asset allocation strategy should reflect the competitive advantages offered by the asset class.
Muni market participants will keep a watchful eye on the approaching mid-term election early next month. We must think about the issues that are most consequential to the municipal bond market. Should the Republicans gain meaningful control, we would expect climate change initiatives and expenditure priorities to fall out of the core agenda and the infrastructure blueprint may likely lose its momentum. While the threat to the muni tax exemption for certain issuer types may become elevated, we are not expecting meaningful shifts, and we do not see any real changes to SALT deductibility or the ability of issuers to advance refund outstanding debt with tax-exempt bonds with greater Republican control.
For a comprehensive portfolio evaluation of your municipal holdings, please contact your Oppenheimer Financial Professional.