Let's Dance, Put on Your Debt-Ceiling Shoes and Dance the Blues, Let's Dance...

A scenario whereby the United States actually defaults on prior commitments would have long-lasting economic, investment, credibility, and global financial stability effects. While we do not expect current events to produce a default on Treasury debt, or at the very least another downgrade, we acknowledge today’s more entrenched and multi-dimensional backdrop of Washington’s political climate as well as today’s slim margins of political control in both the House of Representatives and the Senate. Treasury Secretary Janet Yellen places a worst-case-default-scenario in June, and has already initiated the application of available cash management and other extraordinary measures to avert non-payment of debt service as the U.S. met its debt limit of about $31.4 trillion last Thursday. While such default scenario is likely to be avoided, we could see some shifts in Treasury demand and security valuations as we approach June if nothing is settled sooner. Investors should remain nimble enough to adjust their strategy should the debt ceiling debate run into overtime and the fear of an actual payment default starts to consume the headlines. There are various tools that market stakeholders can utilize as a way to gauge expectations for a debt ceiling showdown within Congress and a current view into the futures contracts does suggest a repricing in Q3 with disruptions along the Treasury yield curve in the form of a yield premium extraction.

While inflation has clearly peaked with evidence of abating upward pressure, overall inflation remains unacceptably high and we must be mindful of the potential price implications of China’s reopening economy. Supply chain headwinds have materially dissipated, but we remain cautiously optimistic given the potential for a key geopolitical event to reignite supply disruption. It is largely expected that policymakers will acknowledge the progress made on the inflation front at the upcoming FOMC meeting, yet they can be expected to posit that our economy is still a meaningful distance from price stability. Furthermore, we cannot rule out the potential for certain aspects of inflation to exhibit “sticky” characteristics as risks to inflation remain weighted to the upside.

While it may be too early to call, consumer spending throughout 2023 is likely to display softer patterns and correspondingly slower growth. Despite a strong labor market, we remain concerned over a near-record low in the domestic savings rate and rising credit card balances and how this will impact consumer preferences moving forward. We are not opposed to a pause at some point in the first half of the year as we believe that previously enacted rate hikes take on a lagging effect and so they need time to work through the economic system as a dis-inflationary process takes hold. Through the coming quarters, growth is expected to slow from earlier projections and so we would prefer to avoid any overzealous tightening actions.

We suspect that the internal FOMC conversation will entertain a possible pause in the rate hike campaign, but we do not expect to receive much clarity or even an acknowledgment on this at the post-meeting press conference. As we make our way to the policy meeting, there is still a disconnect between what the market perceives as the peak Fed funds rate and what the Central Bank is projecting, and with inflation remaining elevated, we do not expect any imminent capitulation from Chair Powell and team. However, more consistently benign inflation prints could move the Fed to find more common ground with market stakeholders.

As we mark the closing days of January, we recognize the sharp decline in muni bond yields with the 10 and 30-year benchmarks down 42 and 40 basis points respectively. Month-to-date, munis may be moving in sync with Treasuries, but tax-exempts are outperforming and they tend to especially outperform when UST prices are selling off. As we anticipated, the 2023 “January Effect” seems to be displaying typical behavior given relatively thin issuance this month and demand patterns that have been buoyed by reinvestment needs. In our view, had it not been for the supportive technicals, the performance spread would likely be tighter. We posit that until muni technicals shift, muni performance is likely to hold firm, yet we have to believe that there are limitations to just how much lower muni yields can fall as a resistance level is probably not far away. It is the strength of muni technicals that can often lead to out-performance over other fixed income asset classes, but should UST fall into an extended sell-off cycle, munis would likely follow suit with their strong technical bias, if still in place, having a visibly diluted impact upon performance. While we began the new year with a favorable outlook for the muni market, we are somewhat concerned over the velocity of the January rate declines and while the Fed appears to be taming the inflationary beast, we do not think it wise to become complacent and allow ourselves to be caught off guard.

Ratios have become rich, not 2021 rich, but rich nonetheless and while institutional investors have cash to deploy and a protracted period of outflows seems to have concluded with renewed deposits into municipal mutual funds, flows remain sensitive to a number of conditions and events and the individual retail investor realizes just how expensive munis have become in such a fairly short period of time. With ratios at such low levels, we have to question just how much more out-performance for munis there is to unlock. Again, we suspect that the current technical backdrop is likely having distorted effects on performance, and if demand holds firm and supply remains low, then performance for munis could have staying power despite tight ratios. Having said this, yield and income opportunities remain compelling and the more recent mutual fund outflows were heavily attributed to year-end tax-loss harvesting, leaving investors to now fucus on the quality, tax-efficiency, diversification, and defensive portfolio attributes of the muni asset class. We anticipate a pick-up in issuance later in the quarter as better marketing levels are available and proximity to refunding opportunities incentivizes capital market access. This may bring about cheaper ratios and better, but not fair, value