Highlights of the week:
The fixed income markets have been on a tear lately. But they may be getting ahead of themselves. Apart from the latest PPI release, recent readings have left market participants feeling that peak inflation is behind us and that the Fed’s target of lowering inflation to 2% is attainable. We, however, have a different opinion on the Fed’s ability to reach that target anytime soon.
November’s nonfarm payroll report showed an increase of 263,000 jobs and a 3.7% unemployment rate, with a positive adjustment to October’s job growth number (284,000). Year-over-year hourly earnings for October were revised upward to 4.9% from 4.7%, and the November number of 5.1% exceeded expectations of 4.6%.
Headlines have been full of reported layoffs in the tech sector, which makes sense if you think back to the pandemic-driven hiring spree by many tech firms (e.g., Peloton) to keep up with demand. We recently heard a talking head state that tech jobs account for 2% of overall employment. If this is true, the headlines are not as ominous as they are made out to be. How long do you think these tech folks will be out of work? So, as usual, fear sells, and the media won’t let the facts get in the way of a good headline. On top of all this, the recent JOLTS survey reported more than 10 million unfilled U.S. jobs.
Fed Chairman Jerome Powell gave a speech last week that many have interpreted as more dovish; we interpreted it as a reiteration of his Jackson Hole remarks. Powell stated that the Fed would continue to raise its Fed Funds rate, but at lower increments; the terminal Fed Funds rate will probably be higher than the markets are currently pricing; and the terminal rate will probably be in place for a longer period than the markets are currently anticipating.
All of this only reinforces our opinion that BARB: Bonds are Back. We believe this is a great time to dollar-cost average into bond positions. We also suggest it’s a good idea to curb your enthusiasm.
Treasury yields moved higher most of last week based on some pretty encouraging data.
Q3 nonfarm productivity inched higher (good news on the inflation front) to 0.8%, exceeding the market’s estimate of 0.6%. Compare that to the Q2 reading of 0.3%.
Q3 unit labor costs came in at 2.4%, lower than an expected 3.1% and Q2’s 3.5%.
However, that began to reverse with Friday’s release of the PPI inflation data. Year-over-year core PPI came in hotter than expected (6.2%, compared to a 5.9% expectation) and lower than last month’s revised 6.8%. The month-over-month core readings were a little more troublesome (0.4%, compared to expectations of 0.2%) and exceeded last month’s revised 0.1%.
All this is a precursor for this week’s CPI release and the December Federal Reserve meeting, where a 50-basis-point increase in the Fed Funds target rate seems to be baked in.
The municipal market continued to outperform the Treasury market as yields moved lower across most of the yield curve. The major drivers of this phenomenon are low new issuance supply and anticipation of the January effect. We do not share this expectation and are waiting for better entry points to put new money to work.
Most Muni/Treasury ratios richened on the week. We continue to think market participants' enthusiasm for the potential of the January effect is a little ahead of itself.
Investment-grade rates followed Treasury rates higher over the week.
President Biden had a pretty good week. French President Emmanuel Macron’s state visit seemed to go well. Sen. Raphael Warnock won reelection in Georgia’s runoff. Brittney Griner returned home in exchange for “Merchant of Death” Viktor Bout — although Paul Whelan and other Americans held hostage by foreign governments remain detained. And gas prices at the pump are declining, but we will have to see how long that continues as China lifts most of its COVID-19 restrictions.
Democrats passed the baton to the next generation of leaders after Speaker Nancy Pelosi announced she would not seek a position of power within the party. Meanwhile, Rep. Kevin McCarthy is wheeling and dealing in an effort to secure the position of speaker in the next Congress. The old adage “be careful what you wish for” comes to mind. Given the makeup of the House, the next two years look interesting.
Finally, Sen. Kristen Sinema declared herself an Independent (joining Sen. Angus King and Sen. Bernie Sanders) but plans to caucus with the Democrats. So, what has really changed? That one is beyond our pay grades.
The 5-year Breakeven Inflation Rate ended Friday at 2.22%, 13 basis points lower than the December 2 closing of 2.35%. The 10-year Breakeven Inflation Rate ended the week at 2.26%, 17 basis points lower than the December 2 observation of 2.43%. Both of these readings seem low, given where inflation is today.
10-year quality spreads (AAA vs. BBB), as measured on December 9, were 0.94%, down from the December 2 reading of 1.30% and still below the long-term average of 1.72%. This reading is at the lower end of the fair territory (as we define it). We still do not think that investors are “getting paid” to take credit risk with forecasts of a recession (even though we believe the likelihood of a significant recession is low) on the horizon. We would need quality spreads to move into the upper portion of the fair territory before beginning a strategic position.
Various sources are used to report cash flows related to municipal bond mutual funds and ETFs, all reporting at different times. The source we have chosen to use is the Investment Company Institute (I.C.I.). The I.C.I. reported weekly cash flows from municipal bond mutual funds for the period ending November 30 was -$2.5 billion compared to -$1.7 billion from the week of November 22.
Municipal bond ETF cash flows cash flows for the same combined period were +$1.4 billion, compared to +$877 million the week of November 22.
Other cash flow sources:
In its Municipal Markets Weekly newsletter, JP Morgan commented on cash flow data this week, stating that:
“Lipper reported combined weekly and monthly outflows of $3.4 billion for the period ending December 7, on muni ETF inflows of $948 million, and open-end fund outflows of $4.4 billion. YTD outflows increased to a new record of $115.3 billion. High Yield funds recorded $606 million of inflows, while Intermediate funds saw $3.0 billion of outflows, and Long-Term funds saw $188 million of inflows.”
In the same newsletter, JP Morgan reported:
“Next week, the surprisingly low supply backdrop will persist, as issuers dodge the Fed meeting and the November CPI data release. We expect gross muni volume of just $3.3 billion, or 26% of the same week average over the past 5 years, and taxable supply of only $257 million is 11% of the 5-year average.”
In its weekly "Credit Flows" report, Wells Fargo commented:
“‘Tis the Season for Hawks. Negative forward guidance from large US banks — and a company or two including VF Corp — set the tone for this week as the equity market declined and priced in a higher probability of recession. Credit however dismissed this risk due to perceived less aggressive monetary policy tightening leading to just small widening in HY and IG unchanged. We look for a higher than expected reading on core CPI Tuesday next week (our economists are at +0.4% vs. +0.3% consensus — feels like could be even higher) to join the much higher than expected Average Hourly Earnings from the November jobs report and force the Fed to bring the hammer to Wednesday’s conclusion of the FOMC meeting. Additionally, the tone into Thursday’s ECB meeting feels hawkish with the central bank likely to deliver details of QT for the first part of 1H23 and at least 50bps of rate hikes.
Too many bonds chasing too little money. With next week’s events setting the tone for markets into year-end we suspect Quantitative Tightening (QT) to set the tone into 2023. Specifically, we expect that early repays of TLTROs (incentivized by the ECB) lead to elevated supply pressure in Europe with spillovers into US Yankee supply in January. This at the same time investors are concerned about the ECB’s intent for formal QT in 1H23.
Relative value in global credit. Looking at relative value of credit spreads vs. equity and rates vol we see US IG is 27bps rich whereas HY and leveraged loans are roughly fairly valued. Of course, EUR IG and HY continue to trade very rich.
HY Corporates: cross USD-EUR relative value screen. Despite higher nominal yields USD HY corporates generally provide negative yield pickup on a currency hedged basis vs. their EUR counterparts. This is because the cost of hedging USD risk into EUR is about 2.5% annually. That means global credit investors can earn higher hedged yields in EUR compared to USD.”
The fixed income markets continue to rally like the worst of inflation is behind us. That might be true, but current inflation is still pretty high. That means the real yield provided by fixed income securities is still negative. A loss of purchasing power is not good for any investment vehicle. We think that Chairman Powell’s speech before the 2022 Community Banking Research Conference did nothing but reiterate his Jackson Hole comments. Other market participants thought differently. Only time will tell who is correct.
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