Lights, Camera, Action... Cut?

As widely anticipated and after much internal debate, our Central Bank unanimously approved a 25-basis point hike in the Fed funds rate, raising the target range, for a ninth time during the current tightening cycle, to a near 16-year high of 4.75% - 5%, and setting market sights on the early May meeting. At the beginning of his post-meeting press conference, Chair Powell provided commentary on the current banking stress, underscoring the ample capitalization and overall soundness and resiliency of the banking system as well as clearly stating that deposit flows have stabilized and that the Fed’s newly missioned funding mechanism now available at its window, which allows borrowing reserves at par, maintains ample liquidity. Mr. Powell expressed the Central Bank’s desire to await incoming data surrounding potentially evolving tightness of household and business credit conditions and to assess such tightening affects upon future policy actions. While additional names could be added to the troubled bank list, Chair Powell does not envision systemic failures (and we agree), yet the banking woes could produce contagion across other confidence and growth-centric activities. Turning to the ever-changing futures contracts, we see that the markets and the Fed are once again reading from different scripts. Chair Powell made it clear that the Central Bank’s base case neither includes recession nor a rate cut in 2023. The contracts are pointing to even-money for a May rate hike, with odds of easier policy advancing thereafter. Should events and circumstances support a monetary cease-fire or even hold steady with evidence of further abating inflationary pressure sprinkled with one or more questionable bank profiles, we would sound an even stronger argument for a May pause.

The data reveals that much of the inflation bite is responding to policy actions, certainly if we consider housing, commodities, and goods inflation generally. Services inflation remains sticky, with heavy demand influences from the leisure and hospitality sector, one of the more deeply shuttered areas of the economy during the pandemic’s reign that continues to broaden its recovery. While it is difficult to equate recent bank-related credit tightening to a basis-point range of increases in the funds rate, recent events have given the Fed some reasonable assistance. An observable credit contraction may very well yield disinflationary, if not deflationary, results upon the economy and the effects for overall growth performance can be quite material. In our view, the banking stress will likely help to move inflation lower from still-elevated levels, and the downside risks upon GDP could exceed the Fed’s own growth forecasts. Admittedly, the consumer is resilient and keeps growth performance within positive territory. However, future participation requires close monitoring as overall activity slows, with collateral damage from the banking dislocations potentially becoming more visible. Future consumer engagement will be particularly assessed in the areas of housing, spending, and general levels of consumer confidence. We suspect that enhanced oversight may bring about greater supervisory and regulatory parity between the large money center banks and the regional banking participants, and should higher capital requirements be mandated for regionals, there would likely be downward impact upon loan activity. As this scenario plays out, there could be another fly in the growth ointment, potentially helping to tip the GDP scales closer to zero or perhaps below. 

The flight-to-quality bid is far from over and it would not be a surprise to see even lower odds for a May rate hike, thus bringing on further divergence between the markets and the Fed. Recession seems embedded in the Treasury’s curve inversion, yet there is still plenty of inflationary sensitivities to go around. The bond market wants the Fed to begin the rate cutting cycle soon as it believes that further tightening against a backdrop of banking stress could plunge our economy into a deep and protracted recession. For now, Treasury yields are likely to stay range-bound, with shorter tenors such as the 2-year likely to respond downward to a Fed pivot, should one come about, and the curve will be assessed for any steepening bias. Municipal bond price movements remain tethered to the vagaries of the U.S. Treasury bond market, yet the asset class has been able to flex a noted degree of independence. Today’s Treasury bond market seeks conviction, preferring to back away its response from the next headline, data point, FOMC meeting, or from the next banking shoe to fall, but munis seem to reflect a demand proposition against thinner supply of primary and secondary product.

With just a few days left in March, muni market participants should be pleased with both MTD and YTD returns against an unrelenting backdrop of volatility, yet we do concede that light primary volume, given the weariness over FOMC and banking stress, is playing a hand in performance.

Having said this, we believe that munis are well-poised to preserve the flashing green through April as long as constructive technicals and market sentiment for a sputtering Central Bank tightening campaign hold in. The flight-to-quality bid will likely be more than just a casual visitor with munis expected to be a key beneficiary given the inherently defensive attributes offered by the asset class. Reinvestment needs have been seasonably light, but this dynamic will be changing as we move through the coming months. We would also anticipate a pick-up in new-issue supply should Fed messaging become more issuer-friendly, with the potential for lower interest rates a likely deal sweetener. While not an absolute, we are anticipating more normalized rate movements, and for this to occur we need to see less volatility and more investment conviction. We continue to posit that any tax-season related selling will take a back seat to a host of macro-level concerns over the next several weeks.