Inflation Trek II - The Wrath of Fed

The bond market appears to still be playing catch-up with the Fed’s unwavering drive to combat inflation, marching decisively to higher yields throughout February. We are eagerly awaiting last month’s employment report, which could either validate January’s out-sized non-farm payrolls print with more pronounced job formation activity, or demonstrate a challenging environment for sustained labor market tightening. On deck, we will gauge the staying power of inflationary pressure with February consumer and producer prices, with the markets hoping to see disinflation securing a viable grip upon the U.S. economy. Let’s recall that last month’s bond market sell-off was catalyzed by the surprisingly healthy pace of job creation in January, and a similar performance for February would likely move Treasury yields to higher ground. The bond market enters March tethered to the incoming data as well as to a seemingly endless parade of Fed-speak. Since the conclusion of the FOMC meeting held just one month ago, we have seen a virtual withdrawal from the pivot narrative, with a growing chorus of stakeholders pointing to 2024 for the first rate cut, a three-month extension of the peak terminal rate to September 2023, and a 58-basis point advance in the peak terminal rate. Although these targets are not set in stone, it would likely take meaningful conviction that the Fed can proceed with less hawkish leanings before we can expect even a modest rollback.

When the FOMC meets next on March 21/22, the markets will have the opportunity to closely examine the revised Summary of Economic Projections with particular attention paid to the “dot-plot” positioning. One of the more visible changes from the December economic projections is expected to be on the 2023 median estimate for the Federal funds rate, which is likely to align with a higher anticipated range of 5.25%-5.5%. Based upon how the data has played out since the December forecasts, we anticipate modest upside adjustments to 2023’s changes in real GDP and PCE inflation, yet our convictions may be skewed as March releases become available. While there are those advocating for a 50-basis point boost, the minutes of the January 31/February 1 FOMC meeting revealed that policymakers largely supported smaller increments of 25 basis points, with only a few of them favoring the heavier move. Should forthcoming data affirm inflationary containment and economic retrenchment, with, for example, evidence that the January payrolls number was skewed by seasonal factors, we would expect bond prices to rally with yields falling back from their currently narrow trading range. While we are not sure if bonds would fully retrace their February losses, we do think that there would be a valiant effort.

The opening day of March seems like an extension of February, with the 10-year UST benchmark breaching the psychological 4% yield. It would not take much to proceed higher, yet it may settle into a new trading range along the way before potentially attaining new highs during the current tightening cycle. Based upon the data, Fed-speak and market expectations, appropriate restrictive policy places the terminal range above 5%, with a closer target (i) certainly higher than the FOMC’s December projections and (ii) likely to be kept in place longer than expected before a downward shift is established. Against this backdrop, we reiterate our call for fixed income allocations given yield and income opportunities and the diversification and quality attributes that help to offset the pronounced vagaries underlying the risk markets. Municipal bonds make an appropriate selection should tax-efficiency be a key driver of the investment thesis. Despite the unique investment attributes of munis, we are likely seeing a greater convergence of market behavior between munis and UST, with munis falling more in lockstep. Generally, fixed income seems to be walking on egg-shells as stakeholders navigate the disruptive forces of prolonged inflationary pressure and uncharted Fed policy. The markets have apparently found religion and although they are now listening to what the policymakers have been messaging for some time now, the upward pressure on bond yields has taken on a life of its own.

Following a strong January with positive returns, munis lost 2.26% in February, modestly outperforming the 2.34% deficit earned on U.S. Treasury securities. Year-to-date, munis and UST are earning 55 basis points and 11 basis points respectively. Fifteen-year and out muni maturities under-performed the broader market, signaling a lack of comfort with Fed policy and cheaper valuations offered on longer-dated securities. In February, investment grade hospital and housing revenue bonds significantly under-performed the overall revenue-backed sector as investors snubbed the wider available spreads on these cohorts amid renewed price erosion in a rising yield environment. Muni high-yield meaningfully under-performed the broader market in February to remind us of the consistent under-performance of high-yield throughout 2022 given the presence of greater duration and rate sensitivities as the Fed moved aggressively to combat uncontrollable inflation. With a pick-up in fund outflows in February, we did see more active high-yield bid-wanted activity for relatively liquid names as mutual fund complexes had to meet redemption needs. The February volume declines of 43% year-over-year reflect an extension of the market uncertainty that was present throughout much of 2022, and it was this uncertainty that kept overall volume down last year. We had an aggressive Fed tightening sequence to address out-sized inflation and that had effectively given the issuer community pause, and we had more of that last month. Good economic news tends to be received in an unfavorable way as it gives the Fed runway to raise the benchmark funds rate higher and to keep it higher for longer. With rates backing up in February, current refunding opportunities dissipated, and the higher rate environment created fewer compelling opportunities for advance refundings. By extension, taxable issuance was down significantly YOY as much of the advance refunding deals come on a taxable basis given that the Tax Cuts and Jobs Act of 2017 ended the ability to sell tax-exempt advance refunding bonds. Issuance may pick up over the next couple of months, particularly if we see reduced volatility and anxiety, with a return to a more normalized issuance schedule. Nevertheless, we have to get through the March FOMC meeting first. We are entering a period of traditional seasonal weakness as the April 15 tax date often gives rise to selling activity in order to meet tax liabilities, and reinvestment needs over the next 30 days are expected to be relatively light. We are still awaiting demand to rise to take advantage of more attractive yields, but concerns over further price erosion seem to take priority. Having said this, should the lighter supply dynamic eclipse the impact of tempered demand, we could see a floor placed on price erosion and so muni investors should be seeking to add positions opportunistically. Furthermore, investors could use the market weakness to trade up in credit quality and structure.