Supply Fears Grip the Fixed Income Markets

WEEK ENDING 8/11/2023

Highlights of the week:

• Inflation data mixed, with expectations of the Fed being on hold in September
• Treasury continues to bring big supply to the market
• China has a liquidity problem

A CITY DIFFERENT TAKE

Inflation data was largely unchanged last week, despite last Thursday’s Consumer Price Index or CPI showing that Core Inflation rose by 0.2%. This was the smallest consecutive monthly increase in the last two years. Warning, there Is another CPI release to come out before the Fed's September meeting. Even though food and energy are stripped out of Core, we are seeing an increase in non-Core prices. This was followed by the Producer Price Index or PPI release on Friday, showing that PPI rose by 0.3% In July, which was more than expected.

What does this mean for the markets? Currently, Fed fund futures are showing rates to largely be on hold for the September meeting, with only an 11% probability for a 25-basis point increase, and a 25% chance of an additional rate rise In November.

What about guidance from the Fed itself? We think this is going to be tricky now that the Federal Reserve is in restrictive territory. Last week we saw conflicting language from various Fed officials; Mary Daly of the San Francisco Fed and Governor Miki Bowman seem to be advising for additional rate hikes, while NY Fed President John Williams and Philly Fed President Pat Harker are advocating a hold policy.

The other theme continues to be mega issuance by the Treasury. Last week we saw $103 Billion in treasury auctions for 3, 10, and 30-year bonds. We continue to expect a larger treasury supply to fund the budget deficit for the government.

Lastly, a quick mention of China's liquidity problem. China's economy has had a tough time rebounding back from Covid with two issues in particular. One is the property market. Country Garden, the Chinese property developer, has suspended trading and is asking creditors for extensions. Second, China's wealth manager, Zhongzhi Enterprise Group Co, has missed several payments on its high-yield debt. They are the largest player in China's $2.9 trillion dollar trust industry.

CHANGES IN RATES

Treasury yields continued to move higher in spite of some fix-income-friendly inflation data. The “bear steepener” was sustained. The spread between two-year and ten-year Treasury security yields finished the week at 0.73%

Municipal yields moved marginally lower last week across the curve. With the supply fears behind us, the municipal market exhibited a slight recovery.

Relative values can change rapidly and with little warning, as they did last week. Muni/Treasury ratios are lower and well below the long-term averages.

Yields in the investment grade (IG) corporate market followed the Treasury market pattern.

THIS WEEK IN WASHINGTON

As mentioned last week, Congress is still in recess therefore so is this section. We don’t have much to report from Washington. The next big Fed announcement will be coming out of next week's Jackson Hole symposium.

WHAT, ME WORRY ABOUT INFLATION?

The 5-year Breakeven Inflation Rate finished the week at 2.42%, an 8-basis point decrease over the 8/04/2023 close of 2.50%. The 10-year Breakeven Inflation Rate finished the week at 2.36%, a two-basis point decrease from the 8/4/2023 close.

MUNICIPAL CREDIT

10-year quality spreads (AAA vs. BBB) as of 8/11/2023 was 1.38% (based on our calculations), 0.02% higher than the 8/4/2023 close of 1.36%. The long-term average is 1.71%. By our way of thinking, lower-quality securities are still not attractive but are moving in the right direction.

Quality spreads in the taxable market are not attractive but were stable last week, ending the week at 0.81%.

WHERE ARE FIXED-INCOME INVESTORS PUTTING THEIR CASH?

Money Market Flows (millions of dollars)

All money fund categories saw positive cash flows again last week. Money market yields are attractive, but how long will that last? If you would like our view on this issue, please reach out to us.

Mutual Fund Flows (millions of dollars)

Flows into bond funds are mixed for the week. It looks like municipal bond investors do not like higher yields.

ETF Fund Flows (millions of dollars)

Bond ETFs were also mixed, with municipals recording a net outflow for the week.

SUPPLY OF NEW ISSUE MUNICIPAL BONDS

This week’s supply estimates are slated for somewhere around a moderate $7 billion again. This should be manageable.

CONCLUSION

We think that the Fed is committed to its inflation mandate. July's CPI and PPI data were mixed; however, we do think that Fed is likely to hold in September. Treasury issuance remains robust to fund the federal deficit. China most certainly has a liquidity problem, with two of Its biggest firms asking creditors for an extension.

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