Don't Stop Thinking About Tomorrow

The Fed’s 15-month tightening campaign has admittedly created wide-ranging market volatility and has kept heavy amounts of otherwise deployable cash on the sidelines. The markets are craving direction and we believe that clarity has to emerge before there could be meaningful investment conviction. A discernable hawkish tone along with revisions to the Fed’s “dot plots” stemming from the June FOMC meeting, where the Committee unanimously held the target range for the benchmark funds rate at 5% - 5.25%, have elevated expectations for possibly two additional rate hikes by year-end, and have caused greatly rolled-back wagers for a pivot to rate cuts through the balance of 2023. Heading into last week’s semi-annual Humphrey-Hawkins congressional testimony from Chair Jay Powell, the markets were poised for an extension of the earlier-in-the-month policy session and that is essentially how things played out. In our view, the Fed is controlling the narrative and although we are seeing more visible divergence among policymakers, Central Bank messaging has been relatively direct and transparent, certainly with Chair Powell’s straight-forward communication skills. We believe this is why the markets were well-prepared for previous rate hikes and the most recent pause (skip if you prefer). Whether or not the Fed’s 2% inflation target is realistic, Chair Powell and team are committed to bringing about price stability, and for now, 2% is their way to meet the task. With this in mind, the journey to 2% may inflict more than minimal damage to the economy and so the Fed is well-advised to proceed with caution so as to avoid a major policy mistake. Policymakers have argued the case that the 2% target is meant to be reached over an extended time period as opposed to being at a set level on a continual basis. With this as a guide, inflationary expectations can be well-anchored while also helping to contain market volatility, yet Fed consensus continues to believe that the risk to inflation remains to the upside. While the July meeting will be “live”, there is no certainty that the Fed will bump rates another 25-basis points. Having said this, futures contracts are signaling a better-than 70% probability of a hike next month, but let’s understand that contracts are subject to sudden and volatile swings from meaningful economic data points and even from the most nuanced Fed-speak.

We agree with the June rate decision, but we prefer to hold judgment on the July meeting at this time. The challenge is to parse through the varied economic releases, distinguish between leading and lagging indicators, prioritize their significance in terms of growth impact, and make an assessment as to implications for monetary policy. The Fed will not only take the inter-meeting period to gauge the economic data, but it will also allow for any anticipated lag effect to take hold while watching for substantive signs of further banking sector stress, even though the collateral damage from higher interest rates has been relatively contained. The current tightening cycle carried the funds rate higher by 500-basis points in a relatively short period of time, and while there may be more rate hikes to come, the pace will be noticeably more moderate. Even though Chair Powell and team are as transparent as they possibly can be with a plethora of Fed-speak, the dots, and a press conference now at the end of every FOMC meeting, events outside of policy actions may do some of the remaining lifting for the Central Bank, obviating actual Fed tightening intervention should more restrictive conditions arise. We believe that we’re moving into a period of more tempered bond market volatility aligned with consistently resilient economic performance, highlighted by an able labor market and a rebound in the housing sector, despite our ongoing call for moderating growth through the balance of this year. Since the conclusion of the June meeting, Fed-speak has been rather hawkish and committed to the idea of further rate hikes should inflation hold to unacceptable levels. Chair Powell has now placed less significance around the actual speed of tightening in favor of systematically finding the correct level of interest rates. More visible softening amid otherwise tight labor market conditions along with below-trend growth coupled with inflationary pressure registering significantly below the dots would likely upend FOMC expectations for another 50 basis points of tightening. Having said this, while the economy will continue to slow in the months ahead, it would be a mistake to underestimate the Fed’s resolve to fight inflation at the expense of contributing to overall economic weakness.

The bond markets have been trading in a tight range throughout June, with munis trading even tighter as technicals have shielded tax-exempts from some of the rate uncertainty. Munis have been demonstrating a firm tone, making up for the losses booked in May. June seems to be establishing a good foundation consistent with our favorable Muni outlook for the second half of 2023 and we expect the favorable bias to remain largely intact as we finish out the year with elevated recession concerns. As we know, muni fund flows are a key barometer of investor sentiment and while we are starting to see intermittent in-flows, we are not ready yet to call a cyclical change, although we do think that the extended period of out-flows has abated. July should benefit with summer reinvestment needs in full swing as Blomberg shows a supply deficit approximating $22.8 billion over the next 30-day period. With the favorable market tone and promising out-performance for munis, ratios, although stable throughout the past several trading sessions, remain on the richer side as value opportunities continue uneven along the muni curve. Although the front-end had shown some earlier relative cheapening, rising Treasury yields and static muni yields with active summer reinvestment have returned ratios to somewhat more expensive levels. In order to capture fairer value, investors must look at longer tenors. With supportive technicals in place, opportunities to capture better relative value over the near-term will likely be hard to come by, and so it makes sense to stay engaged and secure currently attractive absolute yields and cash flow. We will continue to monitor monetary policy and the recessionary narrative and shape subsequent strategic guidance accordingly with an eye on security selection and a preference for those credits and structures offering defensive attributes. This becomes particularly relevant as it is often difficult to bet on rates.

Portfolio reviews are highly recommended with an emphasis on both fundamental credit analysis and diversification, and where appropriate, a reallocation into these security types and generally higher quality bonds may be in order. Admittedly, some portfolios require more adjustments than others given an extended period between portfolio reviews and/or perhaps a lack of professional oversight. We emphasize our previous guidance, particularly for those investors in need of immediate market participation, to allocate a portion of deployable cash into longer dated maturities as a way to capture strategic value with more attractive total return potential should rates revert to lower ground and so curve extensions may be appropriate for those investors unhindered by duration risk and who desire to avoid reinvestment risk. During those periods of pronounced resistance, however, our message is to keep some powder dry and prepare to deploy opportunistically as there could be a risk of portfolio erosion should rates rise. The muni market has proven its ability to operate effectively and efficiently, particularly as the FDIC’s liquidation list was heavily received by permanent investors. The muni curve continues to display a rare inversion along the first ten years, with the longer-end of the curve relatively flat. With this dynamic, investors can consider employing a barbell strategy where you (1) add protection on the short-end given a rise in rates, thus reducing reinvestment risk and (2) lock in higher long-term returns if rates decline. Laddered portfolios can be appropriate as a way to minimize interest rate risk and increase liquidity.