Dive Into Markets Adjusting and Repricing

WEEK ENDING 2/9/2024

• Fed still set on cutting rates this year despite strong economy and slowing inflation.
• Investment Grade Corporate Bond Market repricing to new rate cuts scenario.
• Banks expect further credit tightening.

A CITY DIFFERENT TAKE

Last week was characterized by a host of Federal Reserve speakers. The narrative was the same; easing in rates will come this year.

While it’s unclear when that easing starts, Chair Powell stated on “60 Minutes” that it won’t start in March. The Fed is looking for more confidence that not only will inflation decline to 2% but continue to stay there. The market has shifted its easing bet from March to May, June, or July — recalculating rate cut probabilities with March now at 19%, and May closer to 54%. Fun fact: the National Association for Business Economics polls has shared that about 21% of respondents say that the Federal Reserve is “too restrictive” with regards to its monetary policy.

A public service reminder here that the Fed dot plot is for three 25 basis points cuts this year.

The new shift in monetary policy perception from six rate cuts priced in December of 2023 to now three rate cuts also trickles down to various markets absorbing and repricing this new reality. One such victim is the investment grade corporate bond market.

The Bloomberg U.S. Corporate Bond Index dropped 0.95% in the last week. Credit spreads stand at 95 basis points as compared to the average over the last 30 years of 128 basis points. Treasury rates moved higher on the week as the market repriced the rate cut probabilities. According to the Bloomberg Index, yields for U.S. Corporates rose 13 basis points to 5.31%, while year-to-date returns slid to -1.45%.

The Fed also released its survey of senior loan officers. This survey showed that the banks reported tighter standards in Q4 2023 and experienced weaker demand for commercial and industrial loans. This trend is poised to continue for 2024 where several banks expect to tighten standards for credit cards, auto, construction and other land development projects.

CHANGES IN RATES

This hasn’t stopped the equity market; the S&P 500 Index closed above 5,000 for the first time in its history, no doubt helped by its heavy weighting in the “MAG SEVEN” or, as we call it, the “SUBLIME SIX” if you remove Tesla.

The municipal market’s yields moved higher on the week, closing 0.10% above last week’s close. The calendar is getting close to the end of the “January Effect.” This week’s low new-issue supply will not help matters.

The municipal/Treasury ratios increased marginally during the week, except in the 30-year maturity (municipal bonds became more expensive). Muni bonds are still past breakeven rates compared to their Treasury equivalents.

This market segment was higher on the week.

THIS WEEK IN WASHINGTON

The primary season is in full swing. On February 24, former President Trump faces off against his former U.N. Ambassador Nikki Haley in her home state of South Carolina. At a recent campaign rally, Trump stated he would disregard the NATO treaty. The statement sent a ripple of fear among allies about U.S. support in Europe, as the GOP is currently considering providing additional aid to Ukraine. House Republicans echoed the former president’s statement.

In a new Financial Times poll, former President Trump holds an 11-point lead over President Biden regarding their ability to handle the U.S. economy. President Biden made a rare statement about the stock market, commenting on the strength of the market and confidence in America’s economy.

WHAT, ME WORRY ABOUT INFLATION?

The 5-year Breakeven Inflation Rate finished the week of February 9 at 2.22%, one basis point lower than the February 2 close of 2.23%. The 10-year Breakeven Inflation Rate finished the week at 2.25%, four basis points than the close on February 2.

MUNICIPAL CREDIT

10-year quality spreads (AAA vs. BBB) as of February 9 were 1.25%, 10 basis points lower than the February 2 reading of 1.35% (based on our calculations). The long-term average is 1.71%.

Quality spreads in the taxable market are not attractive but were slightly lower, ending the week at 0.76%. High-yield quality spreads were 3.03% on February 9.

WHERE ARE FIXED-INCOME INVESTORS PUTTING THEIR CASH?

Money Market Flows (millions of dollars)

Money market funds win the week across all segments. Beware of the “Cash Trap.” We are sounding like a broken record, but reinvestment risk is a big money market risk.

Mutual Fund Flows (millions of dollars)

In total, taxable bond funds saw a drop in cash flows from the prior week. Municipal bond funds saw an uptick in net activity.

ETF Fund Flows (millions of dollars)

SUPPLY OF NEW ISSUE MUNICIPAL BONDS

Supply for the municipal tax-exempt calendar will likely remain uneven for the next few weeks, as is typical at the start of a new year. This week’s municipal tax-exempt calendar estimates are $3.6 billion in new issuance. It’s not interesting, but it is uneven.

CONCLUSION

The last few weeks mark a shift in the market sentiment for rate easing. Despite a healthy economy and declining inflation, the Fed has indicated that it will cut rates — but most likely not in March. Corporate credit adjusted to this shift in rate sentiment where the Bloomberg U.S. Corporate Bond Index dropped by 0.95%. Credit continues to remain tight into 2024.

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