With a Debt Ceiling Deal in Hand, Focus is on the Fed

Without dwelling on the political dynamics, it would seem that neither Democrats nor Republicans received disproportionate satisfaction as compromise was needed to bring The Fiscal Responsibility Act of 2023 before Congress (The Act). While The Act allows the government to continue to borrow above the existing cap to meet its obligations and seemingly kicks the proverbial can down the road, the extension does carry beyond the 2024 presidential election cycle, which, theoretically, should keep it outside of the political debate. Effectively, the legislation suspends the $31.4 trillion Federal debt limit through January 1, 2025 and raises the limit on January 2, 2025 to cover the obligations that are to arise during the suspension period. Furthermore, The Act sets new discretionary spending limits for FY 2024 and FY 2025 that are enforced with the automatic spending cuts associated with sequestration. Additionally, provisions of The Act expedite the permitting process for certain energy projects, curtails discretionary, non-defense Federal spending, provides new work requirements associated with various assistance programs, terminates the moratorium on Federal student loan payments (reinstates 60 days beyond June 30), and rescinds certain unassigned COVID-related funds (~$30 billion) and previously earmarked funding for the IRS (~$21 billion over next ten years). The legislation does not provide for a claw-back of state and local government fiscal aid. The Act does nothing to reverse the trajectory of our nation’s swelling debt and spending patterns, despite some temporary deficit relief, with current public debt to GDP recorded at about 119% in Q1 2023 according to the U.S. Office of Management and Budget and Fed data. Should growth perform below expectations, this ratio could move even higher. Given the realities of The Act, the political narrative can easily shift back to entitlement spending and tax reform as ways to target structural budgetary resolve, and this may emerge as the campaign gains ground ahead of the primary season.

With all of this being said, market stakeholders have returned their attention to the data and to the June 13/14 FOMC meeting. The cycle of Fed-speak has ended with the June 3rd commencement of the Fed’s “blackout” period, but not before a number of Fed officials imparted their rather pronounced views on where policy should be headed. As expected, divergent opinions were provided, which, of course, make for a challenging market assessment. With 500 basis points of tightening in just over a year in the rear-view mirror, the decision to vote through incremental rate hikes becomes less intuitive and leads to greater debate during subsequent policy sessions. Last week, the markets had an opportunity to digest fresh labor data, with the release of May payrolls and unemployment taking center stage. Last month added an out-sized 339,000 nonfarm jobs, versus consensus of +195,000 jobs, and the national unemployment rate jumped to 3.7% from 3.4% against expectations for a rise to 3.5%. April payrolls were revised higher by 41,000 jobs to a 294,000 advance. To round out the signature labor metrics, average hourly earnings decelerated to a 0.3% advance month/month, meeting estimates, but lower than a downwardly revised increase from the prior month. Average hourly earnings year/year rose 4.3%, less than consensus and prior growth of 4.4%. The softer-than-expected wage gains underscore the absence of a wage/price spiral and continues to re-direct the inflationary focus to other pricing elements. Although the headline payrolls print continues to illustrate the resiliency of the labor market, the spike was heavily broad-based without disproportionate employment strength on display in any particular area. Professional and business services, local governments and healthcare all experienced noted job creation. The advance in the unemployment rate, which represented the largest one-month gain since April 2020, likely signals the lagging effects of restrictive Fed policy. Let’s recall that in its March Summary of Economic Projections, the median FOMC participant forecast for year-end unemployment was set at 4.5%, and while the unemployment rate could very well move higher throughout the second half of 2023, we would not be surprised to see downward revisions made to forecasted unemployment in the June Summary of Economic Projections. Further evidence of conflicting labor reports came against a backdrop of tighter financial conditions. The April JOLTS release revealed an unexpected surge in vacancies at U.S. employers to the highest level in three months, and followed upward revisions in available positions for March. Recently released data from ADP shows U.S. corporate employment growth in May surpassing all previous forecasts, led by advances in the leisure and hospitality sector. The report comes as various sources indicate that planned layoffs for this year at U.S. companies have significantly exceeded similar announcements made during 2022.

In our view, the mixed nature of the May jobs report along with other conflicting employment data do not offer a compelling argument for a rate hike later this month. The totality of the U.S. economic data should be considered within the context of present geo-political conditions and more recent financial developments that continue to unfold on the domestic stage. We paid close attention to the wide swings in the futures contracts last week, largely driven by the Fed-speak du jour. Following earlier comments made by Cleveland Fed President Loretta Mester indicating that she does not see any reason to pause rate increases, futures were pointing to a stronger argument for a 25-basis point rate hike at the June meeting. Philadelphia Fed President Patrick Harker followed with a view in favor of a June pause. In offering his guidance, Mr. Harker did leave the door open for a possible rate increase at a later meeting. Federal Reserve Governor (and recently nominated to be Fed Vice Chair) Philip Jefferson also voiced his support for a June pause, but like Philadelphia Fed Chief Harker, he has not ruled out further tightening moves if necessary to attain sufficiently restrictive policy. Federal Reserve Bank of Boston President Susan Collins has also indicated that perhaps prior tightening moves have earned a pause. While headline and core PCE for April both exceeded expectations, and consumer spending showed the strongest advance last month YTD, the Fed’s recent Beige Book revealed evidence of cooling performance within certain areas of the economy, yet with a still-resilient consumer. We are also seeing evidence of housing market support as home prices rose for a second consecutive month with buyers competing within a smaller universe of inventory. The housing sector has come under heavy pressure for much of this year and we are not convinced that an enduring housing recovery has taken hold. We should position ourselves for a June pause with the understanding that subsequent data could justify further tightening, and that the Fed should not rule out more restrictive rate territory. We are arguably at full employment, yet tighter credit and financial conditions could unwind this to an extent, and we have already laid out an argument that conflicting economic reports need time to evolve and establish a clearer trajectory. We continue to posit that while passage of the debt ceiling legislation removes much uncertainty, spending and overall economic growth will likely ease through the second half of 2023 and into next year.

With the beginning of a new month, we have the opportunity to once again review muni performance for the prior month. Even though May volume fell by almost 30% year/year (per Refinitiv data), led by an 82% drop in taxable issuance, munis lost 87 basis points last month (one of the worst performing Mays in over 30 years), yet outperformed the 116-basis point and 145-basis point losses posted by UST and corporates respectively. Year-to-date, munis are modestly out-performing UST and under-performing corporate bonds, 2.03%, 1.99%, and 2.69% respectively, although we would add that the performance spread between munis and UST has narrowed considerably since early May in favor of Munis, with tax-exempts now in the lead. We would posit that May Muni performance would have been meaningfully worse had supply taken on a more normal trajectory. Admittedly, we were posturing for better May performance but the debt ceiling debate took on a life of its own. While still too early to make any commitments, munis are enjoying some early-June bumps along the curve. For much of May, we had been anticipating a technical shift in the muni market projected to deliver stronger performance. We are keeping our fingers crossed that our expectations come to fruition. Through May, the debt ceiling saga and concern over tighter monetary policy fostered higher absolute muni yields, escorted by advancing UST yields, and more attractive ratios, which advanced from their yearly lows.

What had previously been overbought and rich areas of the muni market, are now offering better entry points to lock in higher cash flows and potentially stronger portfolio returns should yields demonstrate meaningful contraction. May volume continued the downward supply trend that has framed 2023 YTD, creating a sense of déjà vu. Rising interest rates throughout the month, thanks largely to monetary policy uncertainty and the dynamics of a debt ceiling debate, availability of stimulus funds, generally favorable credit quality, ongoing banking stress concerns, and tempered retail and institutional demand are all contributing factors to the nearly 30% drop in May’s year-over-year primary issuance, keeping many issuers on the sidelines. A lack of compelling market opportunities has particularly held taxable issuance at bay and refunding candidates down to a limited number of transactions. Further, we suspect that most of the refunding activity was tax-exempt as opposed to taxable. Given where muni yields are today, there is little support for taxable advance refundings. While the debt ceiling impasse had factored into rising yields, resolution has arrived and once the June FOMC concludes, market technicals may become the driving force. Bloomberg presently reports a net negative supply of $25.3 billion over the next 30 days, with even deeper supply deficits anticipated for the following two months. With this expected technical shift, municipal bond mutual fund flows may be able to move into positive territory and the well-tested attributes of strong credit quality, diversification and tax efficiency should guide investor preferences. With a more receptive investor community, issuers may find themselves inclined to come in from the sidelines.