A Bonding Experience

Treasury yields remain under upward pressure, and while we still expect the market to stabilize with 10-year yields subsequently returning to sub-4%, the timing may be somewhat longer than anticipated. While there is a long stretch of Fed-speak ahead of the September 19-20 FOMC meeting that will likely impact bond prices, market stakeholders focused with great interest on last week’s annual Jackson Hole, Wyoming economic symposium hosted by the Federal Reserve Bank of Kansas City. Chair Powell was in the line-up for keynote speeches with traders well-poised to respond to his every utterance, tone, and even to what was not said or conveyed at this gathering. At the moment, the hawks are circling overhead looking for reasons to elevate policy to even more restrictive levels. For a number of global Central Bankers, Mr. Powell certainly among them, an argument can be made that monetary policy actions, to date, have left their respective economies in a relatively good place with resiliency underlying overall growth and labor conditions, along with noted disinflationary progress and unrealized recessionary prognostications. Having said this, we prefer to keep our guard up against the potential for a policy mis-step that could send economic growth into negative territory and make that evasive hard landing a reality. Chair Powell and team posit that inflationary risk continues with an upside bias, thus extending concerns for higher interest rates at a time when bank lending standards are becoming increasingly tighter, yet recessionary threats are being pushed out as real GDP growth trends positive and performs beyond forecasts. Mr. Powell's tone was hawkish, but offered some meaningful concessions to the doves in the crowd. Recognizing the progress made through 17 months of the Fed’s tightening cycle, Mr. Powell intoned that familiar statement of inflation still being too high, with the Central Bank standing ready to lift rates higher if necessary.

We interpreted the Chair’s comments as suggesting that the Fed is comfortable staying in the restrictive zip code with an undefined time horizon, particularly given that there was no mention of a pivot to an easing policy trajectory. He was also clear that the risks of tightening too much must be carefully weighed against the risks of not being sufficiently restrictive as the Fed pursues its 2% inflation target. For now, the risks of over-tightening versus those of under-tightening seem to be relatively balanced with FOMC participants working to ensure such equilibrium is maintained. While recognizing concern that the overall economy may not be cooling as expected, Chair Powell did concede that tighter bank credit standards will likely slow growth momentum, potentially diluting above-trend GDP performance. He also observed that labor market rebalancing remains incomplete and that further progress is needed to reconcile the supply/demand dynamic. Pricing for Fed funds futures contracts has been range-bound for much of August, but we witnessed much wider-than-usual variances last week surrounding Jackson Hole. Contracts have been taking the probability of a 25-basis point rate hike at the November meeting to different places, running up and down the 30%-handle, with a higher wager presently at almost 45% post-Jackson Hole. Chances of a 25-basis point bump in September had bounced during the same time frame, but currently stands at about a 20% likelihood. The difficulty that the financial markets have with reconciling the next steps of monetary policy has a lot to do with the fact that the Fed itself is uncertain as to its near-term course, and while this observation may be getting long in the tooth, existing policy actions do continue to have lagging consequences for the economy. 

A run-through of the minutes from the July 25-26 FOMC meeting adds further weight to the argument that policymakers still envision substantive upside risks to inflation, leaving the door open for more restrictive measures. We will be gauging the extent to which the rollout from fiscal initiatives has any accretive benefits upon the U.S. economy as well as any inflationary implications. Consumer preferences and sentiment will remain key to near-term growth performance, and if sufficient evidence arises that the economy is reigniting, there may be an opening for the Fed to enter more restrictive territory as a way to temper any attendant inflationary pressure. In our view, the Fed would require consistent evidence of disinflation, highlighted by slowing core inflation, before giving serious consideration to a pause. While China may continue to exhibit broadening challenges to its economic performance, we expect contagion, if any, to have manageable implications for the U.S. growth trajectory. The August hawks have been circling just overhead, escorting bond yields to higher ground, with the 10-year benchmark seeing its highest levels in 16 years. Admittedly, the bond market has been garnering a great deal of attention, and with even higher rates, the yield and income opportunities grow more compelling. The late summer UST sell-off left municipals with no other option but to join in. Since the beginning of August, 10 and 30-year “AAA” tax-exempt benchmark yields advanced by 34 and 37-basis points respectively. Looking at month-to-date performance, fixed-income is flashing red across the usual suspects, with munis underperforming UST, (-)1.81% versus (-)1.34%. During the sessions leading up to Jackson Hole, Munis were only marginally outperforming, and we suspect that the rich muni curve was prime to underperform a bond market sell-off. If it were not for the benefits of traditional summer technicals, we suspect that munis would be showing even weaker performance. In our view, the sell-off has made currently available yield and income opportunities more compelling, and coupled with favorable credit conditions, muni portfolios can be well-positioned ahead of a potential downturn and can add quality and diversification attributes to a mix of investment asset classes.

As we think about muni credit, we can take comfort with the fact that there is a diversified pool of highly-rated obligors. Investors can also find quality with a structured program that enhances a specific bond issue, providing stronger security elements and a higher rating. The Texas Permanent School Fund (PSF) demonstrates resiliency, strong market access and demand, along with a visible commitment to top-tier prime quality ratings. Moody’s, S&P and Fitch assign Aaa/AAA/AAA ratings respectively to the Texas PSF. The guaranty and top ratings are expected to endure even as the program may come up against a suspension of issuance given elevated guarantees and declining debt capacity. The Texas PSF is, in our view, the strongest statewide enhancement program offered by the municipal bond market. While we consistently maintain that investors should have comfort that the underlying credit has the capacity to meet timely payment of principal and interest, an enhancement wrap can add another layer of protection. Although a well-known structure within the state of Texas, Texas PSF bonds can provide a suitable investment for non-Texas residents and institutional buyers seeking quality, diversification, liquidity and incremental yield attributes. As Texas continues to position itself as a state for relocation consideration with a relatively low cost of living and an attractive business climate, the state’s expanding population is supporting more active bond issuance. In the event of default, holders of guaranteed school district bonds will receive all payments due from the corpus of the PSF. The PSF maintains a well-diversified portfolio based on a quality-oriented asset allocation strategy investing in a wide-ranging equity basket, fixed income, alternative investments, and real estate, with ample cash balances also maintained. PSF is framed by strong state oversight of school districts, ample state support for K-12 education and the minimum credit quality standards for participating districts. To date, no district has called upon the guarantee, largely due to the overall credit quality of the underlying districts and sound PSF programmatic features. Moody’s notes that the weighted average credit quality of guaranteed districts is “Aa3”, and “A1” when adjusted for charter school credit quality. The top 10 participants (median rating “Aa1”) account for 20% of par outstanding. PSF triple - A ratings are also supported by very strong program mechanics that hold if a district is unable to make a debt service payment, it is then required to notify the PSF five days prior to the payment’s due date. School Districts and Charter Schools applying for PSF guarantee must meet certain accreditation and financial standards as required by the Texas Commissioner of Education. The PSF guarantee does not apply to the payment of principal and interest upon redemption, but does extend to required sinking fund schedules. The enabling legislation provides for a funding intercept mechanism that applies to both school district and charter district bond guarantees. The intercept feature obligates the Commissioner of Education to instruct the State Comptroller to withhold the amount paid under the guarantee program, plus interest, from the first State money payable to a district that fails to make a guaranteed payment on its bonds. The amount withheld will be deposited first to the credit of the PSF. For charter district guarantee bonds, the intercept will be used to restore any amounts drawn from the Charter District Reserve Fund as a result of the non-payment after payments to the PSF.