Politicians May Have the Secret Documents, but Munis Have the Secret Sauce

Bond valuations are being driven by growth expectations and calibrations for anticipated recession, yet monetary policy remains influential. There is virtually unanimous agreement that smaller rate hikes are appropriate, yet the divergent thought process is rooted in what the terminal funds rate should be. Futures are also pricing in a rate cut in the second half of the year, which has, for now, been absent from the Fed’s radar screen and we do not foresee a policy shift of such magnitude communicated by the Fed anytime soon. By many measures, existing Fed actions are displaying evidence of meaningful progress towards bringing down the pace of inflation without consequential damage to the economy. We suspect that this observation provides some runway for Chair Powell and team to stay the course beyond the first meeting by putting through modest rate hikes. Having said this, we believe that domestic monetary policy is at a crossroads given likely headwinds to the economy over the coming months. As pointed out in prior commentaries, levels of available Federal stimulus have, in many cases, been significantly utilized, consumer savings have diminished while credit card debt is once again on the rise, and looking at the broadest measures overall, the money supply is contracting. Furthermore, an expanding number of corporations have announced curtailments to their capital spending initiatives.

Inflation adjusted consumer expenditures are down for two consecutive months and headline and core PCE inflation are also lower. Domestic apartment rents advanced in December at the slowest annual rate since mid-2021. A number of states actually reported a decrease in rental prices year-over-year, with some of the larger metropolitan areas exhibiting the heaviest declines. At the heart of the January bond market rally, we can cite market expectations that the Fed will soon acquiesce to a completion of its historically consequential tightening cycle and to a likely Central Bank policy response to a late-year economic contraction. Overall, less hawkish forecasts, weaker demand for goods and services, and improved supply chain capacity have, to varying degrees, been accretive to bond prices. One of our themes for 2022 was the pronounced drop in municipal volume year-over-year given the elevated levels of market volatility as the Fed launched an aggressive tightening campaign to arrest the highest inflation witnessed in forty years. This week’s dearth of new-issue supply is in more typical response to a scheduled FOMC meeting whereby issuers are hesitant to make long-term commitments amid potentially surprising policy guidance. 

Having said this, January 2023 will book one of the slowest issuance months for overall recorded January supply. Admittedly, there is still a hang-over effect from last year and perhaps it may take some time before issuers have sufficient comfort to access the market. We note that a further downward migration in yields would likely open up refunding opportunities and there would be compelling motivation to lock in more attractive borrowing terms for new-money purposes. We do ascribe much of the muni out-performance in January to very supportive technicals rooted in thinner primary supply and very present demand for product, particularly given ample reinvestment needs. Per Bloomberg tracking data for performance, this represents the strongest January return since 2009. The stronger market bias has led the way for a long-awaited return to positive flows into municipal bond mutual funds, with $2.8 billion being deposited over the past two weeks per Refinitiv Lipper U.S. Fund Flows. With heavy demand needs continuing through February, the tone should remain positive and we expect another month of favorable returns and further in-flows. Supply is expected to accelerate in March, and if technicals soften, there could be a dilution in monthly performance. Having said this, we expect continued yield and income opportunities to support more visible inflows and overall positive performance throughout the coming months, although a divergent trajectory could come about in limited fashion. For those performance minded investors, duration extensions and/or downward moves along the credit curve may be necessary.