Stay Cautious, But Stay Engaged And Nimble

The sentiment pendulum is swinging back to an assertive monetary policy tightening bias with a recalibration of interest rate expectations, and dare we say, a higher for longer narrative. When the FOMC meets in late March, policymakers are sure to raise the benchmark funds rate, but the die-hard hawks are circling overhead hoping for something stronger than a 25-basis point hike. Our view remains in support of 25 basis points against a backdrop of recent data signaling economic resiliency and an underwhelming dis-inflationary trajectory. Starting with the out-sized employment report for January, fresh CPI, retail sales, PPI, and manufacturing prints combined to push Treasury yields higher and alter the investment calculus surrounding inflation, interest rates, liquidity, and future growth performance. At this point, talk of a 50-basis point splurge is largely theatre and there is no need to secure front-row seating. While the economy is exhibiting signs of broad-based strength, largely driven by consumer participation, we must be mindful that there are pockets of weakness and bulge bracket corporations continue to announce scheduled layoffs. We are certainly on board with a modest rate increase for next month, and we are not opposed to similar hikes for May and June if circumstances warrant further tightening. The simple reality of the present situation is that pinpointing the number of remaining rate hikes and the peak funds target during the current tightening cycle will remain elusive for both the Fed and for the financial markets. For now, it is purely a matter of interpreting the data points along with a host of Fed-speak. The consumer represents the heaviest gauge of economic standing as this most consequential component of GDP can be expected to exhibit more selective and discerning participation, yet we do posit that a resilient consumer will keep a deep and extended recession at bay.

Given the up-sized February data points for January, the FOMC minutes offered a rear-view mirror look into the policy thought process, yet we are interested in the prospects for more insight into the support for higher rate increases and fresh targets for the funds rate. The convergence of expectations between the Fed and the bond market is evolving with greater pronouncement and we point out that aside from some elevated Fed-speak to the hawkish side, policymakers are essentially telegraphing the same message while the 10 and 30-year benchmark yields have advanced by 54 and 39 basis points respectively since the beginning of February. Contracts are anticipating a terminal rate of 5.37% with the July meeting, versus 4.9% at the beginning of the month. This estimate is subject to adjustments up or down depending upon the data, and such data may give rise to justification for a higher anticipated terminal range of 5.25%-5.5%, visibly higher than the 5.1% median forecast in the Fed’s December Summary of Economic Projections. The presence of stronger economic prints and protracted inflationary pressure would, in our view, give the Fed cover to extend its tightening cycle and solidify a dis-inflationary trajectory with a pause not likely prior to the September meeting.  At the March FOMC meeting, fresh employment, CPI, PPI, and retail sales data for February will be entered into the policy calculus. Should there be a repeat of upside surprises, underscored by tighter labor conditions, market expectations may call for a 50-basis point hike in the funds rate, yet we would remain supportive of a smaller move. Let’s recall that over a relatively short 11-month period, the Fed has lifted the benchmark short-term rate from near-zero to its current target range of 4.5%-4.75% (admittedly much of the front-end moves were normalizing policy as opposed to hitting restrictive levels), and that disinflation has yet to be fully exposed to lagging economic characteristics. 

We acknowledge an eroding political climate in the U.S., particularly given intensifying brinkmanship over the debt ceiling and a fast-approaching Presidential campaign cycle, as well as advancing geopolitical concerns which could have implications for our economy, inflation, and market performance. We also have to be mindful that while current economic conditions are yielding limited deference to the Fed’s tightening efforts, the appropriate restrictive policy, as elusive as it seems, may occur with a swift and decisive impact. Although dis-inflationary forces can be characterized as being in their infancy, the data points could shift with little or no warning just as we are presently seeing how sticky inflationary pressure can be.  Given the performance in the Treasury market, municipal bond yields finally moved higher in sympathy and begrudgingly joined the bond market sell-off, catalyzed by an unexpected (somewhat) return to higher interest rate anxiety as the Fed professes to more assertively bring down the inflationary growth rate. We are seeing new highs being set year-to-date across Treasury bond yields, led by short tenors, and we are beginning to question our assertion that the 10-year is not likely to breach new highs during the current tightening sequence. We may still be correct, but we have to be nimble and realistic enough to shift expectations as we are presented with fresh data and new realities. 

The front-end of the muni curve remains inverted, a rare phenomenon for the asset class that seems to have staying power thanks to the Fed’s tightening gift that keeps on giving. Since the beginning of February, AAA benchmark 10 and 30-year yields have increased by 36 basis points, while the 1 through 5-year tenors saw upward adjustments of between 78 and 54 basis points, taking the brunt of the sell-off to under-perform much of the curve. Although munis behaved as expected by out-performing a UST sell-off for much of the MTD, had it not been for constructive technicals and positive flows into muni mutual funds (conditions that brought relative value ratios to very expensive levels), the out-performance gap would have likely been thinner. Given the events of the past week, munis are now reacting more rationally, under-performing in response to the movements made along the Treasury yield curve. What the performance Gods giveth in January to Munis, has been taketh away so far in February, and while our call for modest single-digit returns at year-end has not necessarily been derailed, the early-in-the-year deficit (February) was not expected. Although Munis are posting a 2.22% loss MTD and earning 58 basis points YTD, they are out-performing UST MTD and YTD losses of 2.37% and 8 basis points respectively. The back-up in rates has pushed relative value ratios modestly higher with the 10 and 30-year benchmarks standing at 65% and 91% respectively per Refinitiv, versus 60% and 87% about one week ago. Richer valuations have been evident for shorter tenors, and despite the yield back-up with short ratios moving disproportionately higher, they remain the most expensive.  As we alluded to, unique muni technicals could, at times, distort performance and relative value, with muni responsiveness to certain market conditions being less than intuitive. We contend that a normalized supply-build could move ratios to more attractive levels, with the 10-year ratio moving closer to fair value and with the 30-year approaching full value. While ratios may be off their lows, they remain expensive relative to historical averages. We believe that there will be those issuers who are likely to remain tentative, for now, given the Fed/interest rate anxiety, and issuance can be expected to be light during the days leading up to the March FOMC meeting.