I'll See Your 25-Basis Point Bump and Raise You Little or Nothing

The evolving banking narrative gives us comfort that a crisis has been averted, but we can not dismiss the potential for further disruptions or even limited exits by certain players within the regional space. With a number of key economic prints for March on the books, the early-May FOMC meeting is now the primary focus. By expanding measures, the Fed’s tightening cycle seems to be yielding intended consequences, but understandably policymakers want more consistent evidence that inflation is target-bound. The markets are seeing real signs of moderating price pressure, particularly in some of the stickier areas such as shelter expenses, and if the data holds course and reveals further inflationary retrenchment, then there could be justification for a pause following what is likely to be a 25-basis point rate increase next month. While a number of policymakers are considering elevated prospects of recession, the general sentiment reflects a modest contraction as many economic indicators continue to point to a tight labor market and overall resiliency. With respect to the banking disruptions, there has been some noted divergence among Central Bankers over the potential impact upon credit extension and consumer activity, with some espousing pursuit of “prudence and patience.” We believe that unless the economy shows heavy declines and/or signs of a deeper credit displacement (i.e. credit crunch), the Fed will likely remain steadfast in its pursuit of a 2% inflation target.

Unknown degrees of credit tightening would tend to take some time to work their way throughout the economic system. For now, it is difficult to advance prognostications for recessionary impact, but we can say with confidence that tighter access to credit would likely slow growth and spending as well as curtail hiring momentum, helping the Fed to achieve its policy objective of price stability. Meaningful adjustments have been made to the futures contracts over the past two weeks, with a 25-basis point rate increase a near certainty for May, following a previous read of barely a 50/50 wager. The peak in the funds rate for the current tightening cycle is now expected to arrive in June, in line with the Fed’s own forecast of 5.1%. Although there is no hint of a pivot to an easing bias from any Fed official, the contracts remain fixated on rate cuts later in the year given market sentiment’s predisposition to an imminent recession. We continue to posit that the FOMC will allocate ample discussion to the evolving banking situation as well as to a more challenging and uncertain geopolitical backdrop, with the latter taken within the context of a recent IMF cut in its 2023 global growth projections, citing elevated uncertainty and risks tied to financial sector stress brought on by tighter monetary policy, and the ongoing war in Eastern Europe. From our seat, we would need to witness more convincing evidence of sustained economic weakness before we join the 2023 pivot bandwagon. 

As suggested, a number of the economic data points look pretty good, yet while the overall housing sector had demonstrated some renewed strength in February, recently released starts, permits and existing home sales were sharply lower in March, a likely by-product of the SVB collapse and ensuing developments. We suspect that higher mortgage rates in April will continue to hold positive housing momentum at bay. Last week’s release of the Fed’s Beige Book showed static economic momentum with a heavier pullback of credit accessibility and lower bank deposits in some districts over others in light of the banking stress. Overall, the Beige Book guidance reflects softer economic conditions compared with the previous edition. Throughout the reporting period, general price levels rose moderately, but the rate of advances slowed. As the FOMC gathers, the most current prints on inflation will be assessed for their relevance upon policy actions. While headline monthly and year-over-year CPI for March came in below expectations, we suspect that the Fed will focus on the core numbers, which matched consensus both M/M and Y/Y. Further slowing of economic activity should bring about additional deceleration in consumer prices, but we must remain mindful of volatile energy and stubbornly high food costs. Service sector inflation remains more entrenched and this is where progress needs to be made. 

Reviewing U.S. Treasury bond market performance, yield movements have been somewhat range-bound throughout April, choosing to focus on rising probabilities of a pause following the May FOMC meeting rather than to pay attention to even the most hawkish Fed-speak. Much of this sentiment can be ascribed to evidence of slowing growth and receding inflation, although upward yield pressure did emerge mid-month as heavier bets for a 25-basis point rate hike in May were placed, but only after the UST 10-year benchmark yield reached its YTD low early in the month. Last week, munis became untethered from the Treasury market and sold-off heavily against a backdrop of both primary and secondary volume pressure as well as capitulation to a nearly two-year low for relative value ratios given that overly rich valuations were simply unsustainable amid a meaningful UST sell-off. Heavier bid-wanted activity became the norm for the week, contributing to the cheaper bias. By the close of business Thursday, the cuts along the muni curve were much less pronounced as compared to the previous session, while 1-10-year UST led the rally in the Government market, and by Friday tax-exempt yield stability set in along almost the entire curve, with a softer Treasury market ahead of the weekend. While muni yields have moved to higher ground, we posit that even cheaper levels are warranted to bring about more retail conviction. Institutional interest varied depending upon the name and structure, with stronger support for longer tenors. 

Timing is key here as muni technicals will soon shift and seasonal reinvestment needs take hold. At that time, we expect tax-exempts to regain some meaningful performance ground against taxables, even if issuance picks up on a more consistent basis following the May FOMC meeting. For much of last week, secondary muni trading volume had been on the lighter side, with the more liquid names finding it challenging to catch a bid, yet picked up late in the week thanks to an active primary. The week's Fed-speak downplaying sharp recessionary fears and arguing for a continued fight against inflation served as background noise, and the end-of-week UST selling pressure reflected above-consensus S&P global U.S. Manufacturing, Services, and Composite PMI reports, exhibiting strength across GDP, employment and inflation fronts. Despite the improved late-week tone for munis, mutual funds exhibited the largest YTD outflow with approximately $2.88 billion of liquidations according to Refinitiv Lipper. Whereas rates and economic data are essentially driving Treasury market behavior, technical distortions are setting ratio levels, with closer to fair value percentages available on the 30-year M/T benchmark, yet with still-rich valuations for earlier maturities. 

As we indicated, ratios could very well move back to richer territory soon and so it is advisable for individual muni investors to deploy cash into the asset class to capture anticipated performance. Muni credit spreads have certainly widened out to their cyclical highs, and remain subject to the vagaries of the economy as well as to any renewed fallout from the banking events.