The Half-Time Show

The second half of 2023 begins with a late July FOMC meeting, with the target range for the Fed funds rate showing rising expectations of a 25-basis point hike. Fed-speak of late has certainly revealed a hawkish bias as there is an overwhelming policy commitment to push inflation lower with an eye on the 2% prize. Presently, futures contracts are capitulating to the prospects of tighter policy against a backdrop of extended economic resiliency, and our well-telegraphed wager against a lower target range through the balance of 2023 appears validated. There were no shortages of fireworks during the holiday-shortened week with the hawkish realities found within the minutes of the June 13/14 FOMC meeting, the persistence of mixed labor market data (with ADP being outsized and BLS below-consensus), and straight-forward Fed-speak signaling more hikes to come. These collective factors handily pushed the benchmark 10-year U.S. Treasury yield out of its narrow trading range and back up to a 4 - handle, the first time since a brief visit in early March, as the bond market visibly sold off. In totality, the fairly benign June labor prints, although admittedly showing cracks in the employment armor as normalization takes root, should not detract from the FOMC’s policy course pointing to a July rate hike following a well-telegraphed pause in June. Perhaps, however, the June employment report may relieve some pressure on a September rate hike given slowing job formation. While the thought of a rate decrease by year-end is out of the trade for now, sentiment ahead of the September meeting will likely be mixed. Policymakers will be looking for signs of abating wage pressure and this week’s tone will be heavily driven by June’s CPI report, which is largely expected to show moderating retail inflation. From our perspective, we need more convincing that a second 25-basis point boost is necessary, and we suspect that the devil will be in the economic details. We would point out that the personal consumption expenditures price index, the Fed’s preferred inflation measure, slowed in May, consumer spending was lethargic during the same month, and certain recently released manufacturing benchmarks have revealed weakness. Offsetting this performance, new home sales rose to the fastest annual pace in over a year, durable goods orders came in above consensus, and a measure of consumer confidence attained its highest level since the beginning of 2022.

Parsing the minutes of the June 13/14 FOMC meeting, there is clear evidence that while the decision to pause was unanimous, there was heavy debate surrounding the move with attention given to the proper messaging for the various stakeholders. There was ample support for an eleventh consecutive rate hike, but the more hawkish participants agreed to keep the target range in place with the understanding that a July rate increase was very much alive. We continue to believe that growth is likely to moderate given the prior banking stress, cumulative effects of tighter monetary policy, and emerging consumer hesitancy as individual balance sheets and cash-flow begin to exhibit some noted erosion. While we have yet to subscribe to the “two more hikes” scenario, persistent economic strength coupled with inadequate progress on bringing inflation lower could alter our mindset. We must also keep an eye on loosening financial conditions throughout the tightening cycle as this could bring about mixed signals on the economy and result in a possible policy mis-step. Whether or not 2% is a realistic objective amid a brand-new playbook written by the pandemic-induced economic shutdown, the global Central Banking community is not inclined to move the goalpost. In our opinion, if the coveted 2% target does find its way into reality, it is not likely to arrive until late 2024 or in 2025 with core inflation prints likely to remain sticky for a while longer. The bond market seems to believe what the Fed has been saying about greater prospects for tighter policy with current Treasury yields now reflecting more realistic levels given historical interest rate correlations, all with a backdrop of technical selling pressure and an unraveling of long positions as prospects for a lower funds rate this year have dissipated. Although Chair Powell and team may have “more work to do”, the end-game is in sight and we do not expect yields to rise appreciably higher. Furthermore, we suspect that there will be a degree of market hesitancy to keep the 10-year much above 4% for an extended period, and, overall, we do believe that the rally in bonds has some additional room to run. Even if we are off-base, the carry trade given the presence of cyclically high absolute yield levels, which is more pronounced for municipal bonds, has contributed heavily to 2023 bond returns, and we continue to argue that reasonable allocations to fixed income provide portfolio ballast with defensive characteristics ahead of the next downturn.

Munis outperformed the Treasury sell-off last week thanks to the seasonal supply/demand imbalance which has produced a heavy supply deficit. If it were not for the supportive technicals, muni performance on the week would have likely dipped further into negative territory, possibly underperforming UST given the richness of the tax-exempt curve. Ratios have become somewhat richer out to the 10-year part of the curve, with fairer value available beyond 15 years. While the value play can be found on longer-dated tenors, duration-conscious investors are deploying cash along the short-end of the muni curve. Despite heavy reinvestment needs, retail has been fairly quiet. Institutional interest remains committed on the front-end where cash is being deployed and bids are active. Issuer participation can be expected to recede ahead of the two-day policy session given a degree of rate anxiety normally associated with these meetings. We continue to believe that munis are poised to outperform Treasuries for the year and finish 2023 with modestly positive returns thanks to constructive technicals and the attractive absolute yield and cash flow opportunities which strongly argue for duration extensions where feasible. We remain confident that retail interest in municipal bonds could become more consistent with greater investment activity should rates stabilize with more subdued volatility. Munis represent a core element of fixed income, underscored by the value of tax-efficiency and long-standing quality and diversification attributes. Munis can also be a source of more reliable fixed income performance, particularly if supportive technicals are in place with tax-exempts often exhibiting social distancing from U.S. Treasury securities, which tend to reveal more front-line reaction to economic developments as well as to fiscal and monetary policies. Should rate volatility remain in full force during the second half of the year and intermittent sell-offs occur in the bond market, particularly if the Fed moves more aggressively tighter than anticipated, munis may very well outperform the weakness. With seasonal technicals taking a firm grip, the depth of the supply deficit is not expected to materially ease for now. Keeping with the 2023 trend, June’s long-term muni issuance declined about 9% year over year according to Refinitiv, but the monthly total was the highest so far this year. At the risk of sounding like a broken record, noted volatility fueled by expectations for higher interest rates have kept many issuers on the sidelines, especially given a lack of compelling factors to market new-money and refunding deals. Against this backdrop, full-year 2023 volume forecasts are not likely to meet initial projections, and, in fact, a number of dealers, including Oppenheimer, have revised lower their supply estimates for the year. Overall volume for the first half of the year is down about 20% and we expect better activity through the second half of the year. Weekly calendars could show greater conviction should volatility subside with a clearer picture of monetary policy movement. Furthermore, it may be more advantageous for issuers to enter the market when demand is elevated.

Circling back to performance, munis had a lot to be proud of in June despite the overriding Fed rate pressure, returning 1% versus a loss of 75-basis points for U.S. Treasuries and 41-basis points for corporates. The flow environment for munis is more encouraging now than at any other point throughout the first six months of the year, despite last week’s reported outflow. Certainly, the year-to-date outflows have trailed the historical withdrawals of 2022 and our expectations for more visible inflows during the second half of 2023 should help to support our favorable performance outlook. Last month, 15-year and out maturities outperformed the overall muni curve given the better relative value available on longer-dated tenors against the persistently rich short maturities. The overall strength of muni credit should also help to boost performance over the coming months. The “Baa” and high-yield credit cohorts outperformed the broader market with a general narrowing of credit spreads becoming more pronounced for these lesser quality securities which were previously at wider spreads relative to higher quality munis. Revenue bonds outperformed both the broader index as well as General Obligation bonds given spread compression as well as investor preferences for dedicated revenue streams with sound underlying legal provisions. The hospital and housing sectors were the best performers within the revenue bond space as recovery and improved spread potential had been more pronounced within these two sectors.