The Markets and Fed; Less Divergence and More Convergence?

Between last week's FOMC and this week's interview, Fed Chair Powell was quite clear that there was more work to be done with respect to further tightening moves, but there was little doubt that the heavy lifting was now in the rear-view mirror given 450 basis points of tightening over the past year and the revelation from Mr. Powell that policy is close to the sufficiently restrictive level. As we anticipated, it was evident that Chair Powell maintains his unwavering convictions over the need for better balance across labor market conditions so as to bring inflation down in broader sectors of the PCE price index, while noting “gratifying” disinflation underway (the markets like the word disinflation, but perhaps it can lead to some level of unjustified exuberance). We suspect that the upside surprise in January non-farm payrolls, coming in at 517,000 versus consensus of 187,000, was not what Mr. Powell had in mind with last month’s job formation and a decline (to a 53-year low) in the national unemployment rate to 3.4%, potentially altering subsequent policy calculus. While the bond market eventually gave its approval and rallied around Chair Powell during his press conference last week, the out-sized employment print catalyzed a very different response with a sharp turn in investor sentiment. We note that post-labor report, futures traders are now pricing in lower expectations for easing during the final months of the year. The modest pace of rate increases will allow the Fed to focus on the inter-meeting rounds of fresh data and to more appropriately gauge the effects of previously aggressive tightening moves upon evolving economic conditions. 

We know that the Chair views the risks from under-tightening as being more consequential than the risks of over-tightening, and that he believes that the Fed possesses appropriate tools to efficiently and effectively ease policy as necessary. The markets seem to have suggested that inflation would move lower at a faster pace than what was being telegraphed by a Fed seemingly focused on an overly tight labor market, yet there may now be some market alignment with Fed expectations. In our view, the January labor report would lend support to the Fed’s mission of attaining a somewhat higher restrictive rate, which quite frankly gives the Central Bank greater policy cover. Keep in mind, Fed-speak can be as hawkish as it wants to be, but reality will likely reveal future rate actions being closely tied to the inflation trajectory and the markets should think in these terms. Thus far, comments made by several Fed officials should have been expected, and do not seem to be at variance with what has already been stated. We know more hikes are coming and that the terminal funds rate may be modestly higher by year-end. The “pivot” should be viewed as an unlikely wild-card for 2023, unless there is a dramatic shift in our economic standing. As mentioned, a “pause” has a reasonable probability of occurring later in the year, but only after Chair Powell and team see meaningful dilution in the strength of the services sector.  

Based upon the current Fed narrative, officials are holding their cards close to the vest and multiple scenarios are on the table. Again, they lose nothing by maximizing policy flexibility. Absent any unforeseen economic and/or geopolitical event, the strength and resiliency of our economy should be able to withstand the restrictive policy being engineered by the Fed. We have concluded that the final resting place for the terminal rate during this cycle will likely be at the upper range of the Fed’s median consensus, which could be adjusted at the March FOMC meeting, as we believe that certain components of the inflationary mix will prove to be sticky, particularly in the services employment sector. We further note that futures traders have moved their peak target funds rate higher to 5.17% by the conclusion of the July policy meeting as of this writing. In our view, the near-term path of bond pricing will likely be influenced by the ongoing data points along with Central Bank messaging. The markets will be on high alert for even a remote hint of a deeper hawkish bias. While we do not think the rally has exhausted its momentum, we do believe that we are approaching a resistance level whereby bond yields are becoming acutely sensitive to further downward movement. Should imbalances between supply and demand remain stubbornly wide, we should expect the “pause/pivot” narrative to fade, yet we do believe that the Fed is approaching completion of its tightening cycle and that 2023 market volatility should pale in comparison to the more erratic moves of last year. 

If our view on rates plays out, opportunities to lock in better entry points may become available. The out-sized payrolls number may possibly extend muni issuer hesitancy to access the capital markets should rate volatility and monetary policy uncertainty once again bestow heavy influence upon primary market activity. While the 30-day forward calendar is building, we will be monitoring rate movements and issuer appetite over the coming days and weeks. Should supply remain on the lower side, we think that strong demand patterns could support muni out-performance in the event of a short-lived bond market sell-off. While muni fund flows turned negative after three consecutive weeks of inflows, technicals are expected to avert a return to an extended cycle of negative flows, assuming that market anxiety in the aftermath of a super-sized employment print can be contained. 

While we can point to the yield and income opportunities available on municipal securities, we recognize that current valuations are less than compelling given how rich munis are relative to UST. Again, we can cite better valuations today than what were available throughout much of 2021 when munis were even more expensive. Our strategic guidance calls for close examination of muni/Treasury relationships with the identification of cheapening momentum during those times when munis lag in performance. Although a natural investment inclination may be to extend duration and/or roll down the credit curve, we caution against decisions that would sacrifice the integrity of suitability guidelines and investment objectives. Demand is clearly evident, yet there remains ample sidelined retail cash awaiting better entry points and valuations. Given periods of pronounced retail resistance, our message is to keep some powder dry and prepare to deploy opportunistically. For those investors in need of immediate market participation, we believe that existing yield and income benefits, along with tax-efficiency, above average credit quality and diversification attributes can provide sufficient justification.