Muni Sell-Off Creates Opportunities
Last week’s rout in the bond market, that will prove to be quite memorable, was catalyzed by a wager placed by fixed income traders that perhaps the driving forces of inflation would move the Fed’s hand to act sooner than expected and raise short-term interest rates. We still do not expect a Central Bank course deviation in 2021, and the “zero” bound Fed Funds rate may very well extend beyond this year given that the national economy is a long way from full employment and that the Fed’s fairly new inflation guidance calling for an average 2% price run allows for some overheating as well as policy flexibility. Throughout the foreseeable future, the monetary policy narrative will center upon job formation and the ongoing application of the COVID-19 vaccine along with declining case transmissions. In our view, 2021 was destined to exhibit greater volatility across a broad swath of the financial markets simply given an anticipated harder reopening of the national economy, subject to fits and starts and the vagaries of the vaccine roll-out. Let’s be clear, we are emerging from an unprecedented, self-imposed global economic shuttering of crisis proportion and so absolutely there is going to be inflationary pressure, yet we are aware of the fact that there is little historical context that can help guide our way for anyone searching for a playbook where there is none.
While we do believe that the bond market sell-off has been over-done, we do recognize the elevated probability of even higher rates. The Fed will eventually need to telegraph a carefully orchestrated retrenchment in its unconventionally accommodative bias, which has endeared itself to a degree of out-sized risk-taking thanks to a great wall of liquidity, in such a way so as to minimize a more sustained market backlash. While the Fed would seem more desiring of market stability, the Central Bank may be content for a while to allow bond yields to find a new trading range more indicative of economic normalization and as a way to possibly adjust a mispriced interest rate environment, thus permitting activity to slow more organically.
We knew it was just a matter of time before munis acquiesced and began to ride the Treasury yield rollercoaster up to higher ground. Now we must reflect upon our standing guidance offered to muni bond investors encouraging opportunistic acquisitions at cheaper prices. Most market participants would agree that recent events have created appropriate entry points for the savvy investor. The 40-plus basis point rise in long muni yields since the beginning of February against an unrelenting sell-off in the Treasury market has created some noted institutional interest, yet we are awaiting visible retail support at these new levels. Municipal bond mutual fund flows are under pressure, along with a particular exodus seen in muni ETF's, following record inflows in 2020.
We think that when the market settles into a new range, the adjusted relative value ratios will be more realistic and should draw in more investors. For now, the muni sell-off has paused and we think the new levels merit a look. Given that munis started their upward migration in yields after Treasuries, there may be more upside room to go. Having said this, newly minted valuations may be catching the eye of those investors kept on the sidelines given rather frothy price levels and indecipherable market volatility of late. All along, we have been suggesting that 2021 may see more disruption/volatility in fund flows, with perhaps a slower pace of inflows or even intermittent bouts of outflows, yet we do not envision a sustained period of outflows given our technical views.
For a comprehensive portfolio evaluation of your municipal holdings, please contact your Oppenheimer Financial Professional.