Will November Bring a Muni Thanksgiving?

While the stance of monetary policy is restrictive with tight policy placing downward pressure on the pace of inflation, the Fed admittedly lacks confidence that policy has attained a sufficiently restrictive level. Although the economic view was upgraded in the FOMC statement to expand at a strong pace, tighter financial and credit conditions have an elevated probability of weighing on economic growth. The Central Bank acknowledges concern over the sharp October rise in bond yields while continuing to determine the extent of additional policy firming that may be needed to achieve the price stability side of its dual mandate. Last week’s words from Mr. Powell reiterated past comments that the FOMC is not presently discussing rate cuts, and we note that recession has not been placed back into the Central Bank’s staff forecast. Treasury prices managed to hold firm and catch a strong bid before, during, and after the Chair-speak, signaling that while a pivot is not expected to be a near-term event, there is now greater market conviction that the Fed’s rate hike campaign has reached its cyclical conclusion. We continue to argue that the full effects of 525 basis points of tightening have yet to circulate throughout the economy and that expectations for slower growth and softer labor market conditions would drive the inflationary pace even lower. The key area of the economy to keep an eye on is consumer engagement as consumer spending has been supported by a resilient labor market, yet labor supply/demand conditions are coming into better balance given slowing job gains and a rise in labor force participation. Q4 activity will likely be exposed to the effects of student loan payment re-engagement, smaller income advances, the potential for increased layoffs, weaker manufacturing activity, growing concerns over U.S. deficits, global economic implications of geopolitical events, and narrowing household savings rates. The bond market continued to firm on softer employment data for October, headlined by an increase of 150,000 nonfarm payroll jobs versus consensus of plus 170,000. The national unemployment rate rose from 3.8% to 3.9% and we believe that the jobless rate will likely settle in at a level notably above 4% at some point next year. Here we note that the effects of the 30,000 UAW strikers will likely be reconciled in the November prints. 

Although there is evident normalization within the labor market in support of concluding the rate hikes, we suspect that there are divergent views among Fed policymakers as to whether further tightening is necessary. This is where forthcoming data on economic growth and inflation is of meaningful importance. Should tightening conditions within the labor market remain stubbornly present, ongoing progress to curb inflation could be placed in jeopardy with additional rate hikes very much on the table. With all of the bond market euphoria, the 10-year UST benchmark yield declined by 40-basis points since October 19th, with the 2s/10s yield curve inversion now more inclined to unwind after becoming such a longstanding presence. Nevertheless, the 100-basis-point sell-off that took root in July, using our 10-year UST proxy, has left open wounds and while we do not see the benchmark yield testing new highs for now, we are mindful that several pre-existing conditions could take hold of the current trajectory and push yields intermittently higher from current levels. Having said this, the yield and income opportunities that have availed themselves given the Fed’s historic tightening sequence remain firmly in place with bonds offering more than portfolio diversification attributes within a comprehensive asset allocation strategy. While Treasury market technicals typically do not align with the relatively unique seasonal technical attributes commonly associated with the muni asset class, foreign buyer preferences can have a meaningful impact on the demand side of U.S. government securities, and we suspect that this dynamic will help guide the narrative over the near-term. 

While munis have now revealed negative returns for three consecutive months, the asset class outperformed UST and corporates last month. Portfolio performance remained weak in October for many investors taking on fixed income duration risk with the expectations that the Fed was approaching the completion of its tightening campaign even though the recession and pivot cans were kicked further down the road. Market stability has been scarce throughout 2023 and we have grown increasingly concerned over the accelerated back-up in yields of significant proportion during October that had the potential to bring on recessionary pressure. With October muni performance now in the rear-view mirror, the focus has shifted to November where favorable returns defined the second-to-last month of the year over the past five years. Admittedly, we are living through a period where conventional wisdom loses ground thanks to a market backdrop of disproportionate volatility and so, we should not be surprised if there are sharp deviations from otherwise anticipated scenarios. Unless inflation surprises to the upside, and/or growth holds or exceeds its current course, monetary policy should more decidedly be viewed as sufficiently restrictive with the bond market becoming less reactionary to rate expectations. We would also prefer that the Fed be less reactionary to each and every data point through its chorus of Fed-speak as a way to further reduce episodic volatility.

A key driver of November muni performance should be technical factors, with new-issue supply typically on the lighter side and reinvestment demand at active levels. While cash allocations into the municipal asset class are appropriate given the yield and income opportunities, we are mindful that tax loss harvesting could offset the accretive benefits to fund flows and pressure secondary bid-wanted activity. Having said this, we are in favor of cash allocations into the asset class given prospects for muni out-performance through the remaining weeks of 2023. We believe that forthcoming data will reveal a further slowing of economic conditions with more disinflationary progress taking hold. As we prepare for and enter 2024, we can expect contained market volatility with yield curve normalization taking on a more visible presence for UST and munis. The days of near-zero interest rates have been relegated to the history books and investors will grow into new fixed income trading ranges as the Fed takes its tightening bow. Munis are outperforming UST month-to-date and we expect constructive muni technicals to do what they are supposed to do - drive tax-exempt returns to higher ground. Through year-end, muni supply should remain well-received and dealers should continue to appropriately manage their inventory balances. For much of the earlier part of this year, ratios were stuck in expensive ground, yet we have been seeing better relative value opportunities. While ratios have yet to offer fair value, we would say that the market has moved closer to fair value throughout the second half of 2023. As muni yields approach the yield on a comparable Treasury, muni investors are able to capture more of the tax benefits of owning munis. We especially note that periods of muni underperformance give rise to value opportunities as the asset class cheapens and when the underperformance is followed up with spread tightening circumstances. Even though ratios are below their long-run averages, a better value proposition coupled with attendant yield and income opportunities present a compelling argument for the deployment of capital into municipal securities.