What Is a Fed to Do?

As we approach the end of the first quarter of 2023, we find ourselves conceding the realities of broader and deeper market volatility than initially anticipated leading into this year. The Fed’s commitment to its 2% inflation target against a backdrop of unrelenting price pressure had fostered a policy narrative of higher, faster, and longer. The operative word here is “had” and given the collapse of Silicon Valley Bank (and last week's bankruptcy filing) and the collective intervention from Treasury, the Fed, and the FDIC designed to open that Fed window wide and avert a systemic crisis in confidence, the flight-to-quality trade enveloped much of last week. As stakeholders processed the February CPI prints last Tuesday, which were underscored by meaningful upward price pressure for core services, the risk appetite returned and UST gave back some earlier gains booked last Monday. The proverbial “other shoe” dropped on Wednesday with an expanded focus upon the fragility and frailties of the European banking system, highlighted by renewed concerns over Credit Suisse’s financial standing, consuming the global stage, sending equity valuations substantially lower and igniting a bond market rally of historic proportion with a more pronounced inversion along the Treasury yield curve. By early Wednesday afternoon, we saw some recovery within the equity markets as efforts to stabilize Credit Suisse were underway. Moving into Thursday afternoon, banking contagion anxiety eased somewhat as both domestic and international relief efforts for a number of institutions gained promising momentum, leading to renewed appetite for risk assets and lower Treasury prices across most of the curve.

Back home, First Republic Bank found itself facing collateral damage, resulting in a temporary fix through a $30 billion infusion of uninsured deposits by a consortium of large U.S. banks. Over this past weekend, UBS inked a $3.2 billion deal to acquire Credit Suisse, but the agreement came with heavy backstops from the Swiss National Bank. Whether these remedial actions can stem a debilitative tide of contagion, the process will need to play out over the coming weeks and months with the financial markets standing ready to respond accordingly. While we do not see systemic failures for the banking system, we do believe that the rules of engagement are heading for change with managerial, operational, supervisory, and regulatory (perhaps not as pressing as the others) adjustments all part of the debate. There needs to be stress testing of sudden and rapid rises in interest rates and implications of curve inversion, long-duration risk, and overall asset/liability management as part of the broader risk-modeling process, and at the very least, smaller banking institutions may end up being held to the same capital and liquidity standards that envelop the larger financial enterprises. 

Let’s think about likely monetary policy scenarios. As we know, the U.S. Central Bank is bound by a dual congressional mandate of full employment and price stability. Routinely, we examine the Fed’s impact upon financial stability and how the Central Bank interprets such impact. We recognize that supervisory and regulatory oversight of our domestic banking system falls within the Fed’s purview, and simply looking at the behavioral interrelationships, we pose the question, without financial stability, how can the Fed achieve full employment and price stability? When the FOMC meets this week, the policy calculus should take on different dimensions. Although core services inflation signals still-sticky and troubling CPI pricing, declines in February producer prices and retail sales demonstrate receding inflationary pressure. We suspect that the weaker UST activity last Thursday was part profit-taking and part building anticipation ahead of this week’s FOMC meeting, yet the banking anxiety took hold on Friday with the bond screen flashing green in true St. Patrick’s Day spirit. Expectations for the meeting have shifted just about 180 degrees with the futures contracts telegraphing lower, faster, and longer. Let’s just say that recent support for a 50-basis point hike (strengthened by Chair Powell’s hawkish comments during recent Congressional testimony) in the funds rate has been relegated to fantasy world and even a 25-basis point lift seems to be moving closer to the edge of the table.

Fed funds futures reflect an accelerated conclusion to the Central Bank’s tightening cycle thanks to recent banking sector events. The probability of a 25-basis point rate increase has advanced since the middle of last week, yet the forecasts are less than compelling. While we can make an intellectual case for a pause given financial stability concerns, and even support one for this week, we believe the likely outcome will be a 25-basis point raise to bring the target range to 4.75% - 5%. Just like Christine Lagarde views the ECB’s capacity to dual track its inflation fight, while preserving stability within the banking sector, perhaps Chair Powell and team may be of a like mind. Given the notion that a 50-basis point increase is out of the wager, 25-basis points would seem to strike a fair balance as inflation remains excessive and we view its economic significance as being modest. In any event, we believe that post-meeting messaging takes on critical importance. Should the Fed vote to raise the benchmark short-term rate by 25-basis points, it would likely resonate with Central Bank credibility, and could be construed as appropriate given recent events within the banking sector, with recognition that this is not 2008 déjà vu. Even before the banking developments, we were on the side of 25-basis points as opposed to 50, and so Chair Powell would be well-advised to embrace a higher probability for a pause perhaps at the early May Meeting. Additional cover can derive from cooling wage growth and the recent PPI and retail sales prints.

We would also like to hear the Chair’s thoughts on future balance sheet management concerning further quantitative tightening against an evolving backdrop of maintaining sufficient reserves to meet demands placed upon the Fed’s newly crafted Bank Term Funding Program. This could be interpreted as quantitative easing with a fresh build-up of balance sheet assets. Market stakeholders will likely seek guidance on the Central Bank’s management of rate increases and balance sheet roll-offs. This is exactly where the Fed needs to demonstrate its nimbleness, and any mis-step will subject the policy-setting arm to widespread criticism. While the Fed is not likely to terminate its QT program over the near-term, it may decide to roll-back scheduled liquidations. Circling back to the futures contracts, expectations are now showing a peak funds rate arriving in May with a 4.8% handle and cuts coming as soon as June. From the March FOMC meeting through year-end, contracts are currently pricing in 88 basis points of easing. Just two weeks ago, the terminal rate was expected to come in September with an implied rate of 5.45% and no anticipated rate cuts through the balance of 2023. 

As repricing in the Fed funds futures market moved aggressively, the flight-to-quality bid sent the UST 10-year benchmark yield lower by about 60 basis points since March 8th. The two-year plummeted by over 120 basis points during the same period, after the short benchmark attained a multi-year high of 5.08% during Chair Powell’s recent semi-annual testimony. Of course, Munis joined the flight-to-quality bandwagon with 10 and 30-year AAA benchmark yields dropping by 23 and 16 basis points respectively. Price advances have been more pronounced on the short-end of the muni curve as yields on the 1 and 2-year tenors declined by 40 and 39 basis points respectively. The more significant pull-back on short-term yields reflects the heavier sell-off previously witnessed along the short-end, which has preserved the muni curve inversion. Following movements in the Treasury market, we expect the muni curve to steepen, yet such trajectory may be short-lived. Overall, the flight-to-quality has largely overshadowed muni market technicals, macro themes, and the inflation story. 

As we move through the current period of uncertainty, we emphasize the quality attributes of the municipal bond asset class. Preservation of capital should be a paramount investment consideration and portfolios should be fine-tuned to maximize a defensive bias that could produce resiliency during an economic contraction. We have witnessed orderly flows and efficient trading activity of municipal securities during periods of market uncertainty, and we expect similar performance amid the banking sector challenges. While we can identify pockets of credit concerns, the overall market stands ready to produce viable performance during the next recession, which could emerge sooner than previously anticipated thanks to slower growth prospects tied to the banking sector stress. A number of high-profile credits have been upgraded since the early days of the economic reopening and we expect more improvement to come, yet weaker tax collection activity and revenue performance within certain sectors could dilute the positive credit momentum. There are still many municipal issuers that have access to stimulus funds, and improved reserves and rainy-day accounts will help to preserve currently assigned ratings. Coupled with prudent debt management practices, a stronger financial position should continue to weigh on issuance decisions. Technicals have improved somewhat with a net negative supply forecasted over the next 30 days according to Bloomberg data. This week’s calendar is expected to be lighter given the banking uncertainty and the FOMC meeting. Having said this, the supply backdrop could produce a stronger primary bid. With retail having a discerning eye and thinning product availability expected, meaningful cash deployment will likely encounter headwinds. We expect any ensuing selling pressure to be more aligned with rate uncertainty as opposed to fundamental concerns and April 15th tax-related liquidations. 

As we think about the banking situation, we must consider possible shifts in buyer preferences exhibited by banks generally as a key investor class of muni bonds. The 2018 Economic Growth, Regulatory Relief and Consumer Protection Act, among other things, reclassified municipal bonds as high-quality liquid assets and provided another vehicle for banks to help meet their liquidity needs. While active investment by banks has generally been softer more recently, this buyer class has remained part of the muni liquidity profile. As regulators convene to discuss a way forward for banks in the wake of SVB, attention may be focused on munis, and while it is too soon to advance substantive prognostications, we will be on the lookout for anything that impacts demand for the asset class. Even with the lower corporate tax rates created by the Tax Cuts and Jobs Act of 2017, banks have remained a significant holder of munis, albeit with higher allocations into taxable munis. Again, we will closely follow bank flows for any meaningful selling pressure.