WEEK ENDING 9/16/2022
Highlights of the week:
- The Federal Reserve Fireworks
- CPI data, while trending in the right direction, shows slow progress
A CITY DIFFERENT TAKE
Last week, Sweta was reminded that she belongs to Generation X, also known as the generation succeeding the baby boomers. Another name for her generation is the “lost generation,” couched between the Millennials and the Baby Boomers. Why this matters in the context of our weekly commentary is that Sweta missed the Volcker Federal Reserve in all its glory. However, Jay Powell is more than making up for it with the recent Federal Reserve fireworks. While Chris has managed assets during more aggressive Fed policy periods, there hasn’t been a more powerful Federal Reserve approach in Sweta’s 20-year career in the fixed income markets.
It's almost as if the Federal reserve has one mandate right now - to tame inflation. The strong labor market has the Federal Reserve zeroed in on controlling inflation. This Wednesday is Fed Day once again, and according to the CME Fed watch tool, there is a 78% probability of Powell announcing a 75-bps rate increase. Meaning there is still a 22% probability of an alternative – including an even more aggressive 1% rate hike. Supporting this singular mandate is a robust US Labor market. The unemployment rate is at a healthy 3.7%, and there are currently 11 million job openings in the US which are 4 million more than pre-COVID era.
The August CPI number was surprising for the markets, with headline and Core CPI numbers at 8.3% and 7% YoY, respectively. Core CPI is three times the Fed’s target. The increase is broad-based across all sectors, with food and rent being among the stickiest. Markedly, gas prices have been coming down for the last 12 weeks, which is good for the consumer, whose price at the pump is their daily read on inflation (in addition to their grocery bill). This drop in gas prices times well for the Democrats with the upcoming midterm election and the President’s approval rating, but the overall inflation rate continues to be a challenging issue.
The probability of the Federal reserve terminal rate ending at 4-4.25% for the December 2nd meeting stands at 37% from the CME Fed funds watch. If you track sell-side analysts, the numbers are as high as a 4.9% terminal rate in January 2023 (Deutsche Bank). However, we at City Different Investments believe that the writing on the wall is clear—a higher federal funds rate for an extended period going into 2023.
CHANGES IN RATES
Interest rates in the Treasury market moved higher last week. The slope of the yield curve remains inverted from 1 to 30 years.
Municipal interest rates have been moving higher. The front-end rates moved higher still.
Muni-Treasury ratios were lower still last week, showing that Munis are holding up in value much better than their treasury counterpart. A higher M/T ratio tends to make Munis a more attractive buy.
Investment-grade rates marched higher as well. The increased delta was much higher in the front-end tenors.
THIS WEEK IN WASHINGTON
President Biden will have a busy week going directly from London, after paying respects to the Queen, to a United Nations meeting in NYC. However, two of the most important pieces of news generated by the President were—The US’s open proclamation to defend Taiwan in case of an ‘unprecedented attack’ by China, and the possibility of Biden not running for reelection in 2024.
WHAT, ME WORRY ABOUT INFLATION?
The 5-year Breakeven Inflation Rate ended at 2.27%, 6 basis points lower than the prior week closing at 2.33%. The 10-year Breakeven Inflation Rate ended the two-week period at 2.38%, 4 basis points lower than the last reported observation of 2.42%.
Quality spreads continued to widen, moving further into the fair range, and are starting to pique our interest. While we don’t think the move has been significant enough to change our strategic outlook towards credit, it's getting close.
WHY IS THE MUNICIPAL MARKET BEHAVING THIS WAY?
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 week of September 7th as -$2.0 billion compared to -$2.6 billion from the week before.
Municipal bond ETF cash flows for the same period were $130 million, compared to -$72 million the prior week.
Other cash flow sources:
Lipper reported a 6th combined weekly and monthly outflow, with $1.5bn leaving muni funds, increasing YTD outflows to a record $85.9bn.
SUPPLY OF NEW ISSUE MUNICIPAL BONDS
In its Municipal Markets Weekly newsletter, JP Morgan commented on the supply picture this week, stating that:
“We expect total supply of just $1.4bn, or 15% of the 5yr equiv week avg ($9.5bn), as issuers want to avoid rates volatility during the FOMC meeting. We anticipate tax-exempt supply of $1.4bn (18% of avg), and taxable/corp cusip supply of $35mn (2% of the avg).”
The supply picture does not get interesting until it exceeds $10 billion in tax-exempt issuances in a given week.
CORPORATE INVESTMENT GRADE AND HIGH YIELD OVERVIEW
In U.S. Investment Grade land, spreads widened slightly to reflect pushback from the strong US CPI data.
In its weekly "Credit Flows" report, Wells Fargo commented:
“IG credit spreads widened 2 bps this past week to 142 bps despite hotter-than-expected inflation data and a sharp pullback in both Treasuries and equities. IG yields surged 18 bps to new YTD highs of 5.1% for a total return of -1.0%, extending the decline since July to -5.3% and cumulative YTD losses to -15.8%. Across the curve, front end spreads were fairly anchored, with 1-3 year spreads tightening 2 bps and 3-5 year spreads widening just 1 bp. Intermediate 7-10 year and long end 25+ year credit underperformed with the selloff in yields as spreads widened 4 bps. At the rating level, BBBs modestly outperformed As and AAs as spreads widened 1 bp, 2 bps and 2 bps, respectively. At the sector level, long duration Communications and Transportation notably underperformed with spreads leaking 4-5 bps wider, while spreads in sectors were unchanged to 2 bps wider.”
However, the more interesting take on Wells’s point is what's happening in the Quantitative Tightening world.
“Let it QT. While the topic of Quantitative Tightening (QT) gets relatively little attention these days, we find it important to point out that since Treasuries mature either mid- or end-month, yesterday (Thursday) was the first time the Fed received max run-off of Treasuries with no intent to reinvest $60bn/month (up from $30bn/month) after QT stepped up to full speed September 1st. The way QT works is that private investors will now have to step up and fill that void – i.e. sell portfolio holdings to buy Treasuries that are no longer bought by the Fed. That leads to selling across the board, which is much like in forced deleveraging. Despite the weakness in risk assets during the first part of the year major global central banks actually did QE in aggregate through May. Since then balance sheets have declined a little – now set to accelerate the decline (QT). Wider spreads, lower prices.”
- The Powell-led Federal reserve has matured into a strong Hawk.
- The CPI report and strong jobs number transform the Federal reserve mandate to a singular one of solely taming inflation.
- The rhetoric on the year-end terminal rate is north of 4%. Higher rates for a more extended period are in our future.
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