Munis Are A Good Bet

The summer of 2022 illustrates our often-expressed notion of an interest rate trajectory beholden to an inflation/recession tug of war, with the inflation hawks now seeming to gain much stronger footing. The past week had market participants hyper-focused on Central Bank messaging originating from this year’s Jackson Hole, Wyoming economic symposium. Jackson Hole is not typically known for surprise announcements or prognostications, but enough anxiety built up during the week to hold the 10-year Treasury benchmark yield over 3% and renew sharp market volatility across multiple risk-asset classes. For those stakeholders anticipating some hint of a pivot, there was obvious disappointment, but in reality, we were told quite directly ahead of Jackson Hole that further policy moves would be data-dependent and that the Fed is committed to bringing inflation down to its 2% target even at the expense of curbing economic growth. It appears that consensus within the FOMC has been in place since the July policy meeting given the heavy doses of Fed-speak telegraphing that more restrictive measures are likely needed to achieve the Central Bank’s objectives.

The Fed has much to gain by sticking with a hawkish script and strong rhetoric, but everything to lose if it does not bring inflation under control. We take the Fed’s messaging at its word that future policy moves will be data-dependent, at the expense of forward guidance, which has been met with credibility headwinds, and so one would truly need more than just a crystal ball to accurately identify the timing of a policy shift. The narrative now reflects a “higher for longer” theme with a more enduring restrictive policy bias. While there is probable merit to this position, we would likely have great difficulty in reaching consensus on assigning a duration target to “longer”, which could realistically extend beyond a year should the economy respond more slowly to restrictive policy actions. Of course, the data will be the guiding light and while growth can be stifled to some extent, we do not see the Fed intentionally throwing our economy into a deep and entrenched recession. Nothing out of Jackson Hole provided an indication of a pivot in early 2023, and in fact, we think that the futures market would have adjusted more noticeably in view of current Fed rhetoric. Having said this, we are not ruling out the scenario presently being illustrated by the futures contracts, as the implied rate would be at the midpoint of the official policymaker range by the end of the first quarter of next year.

We continue to believe that unless we see compelling evidence in support of more aggressive tightening, we would argue for a 50 basis point increase in September, particularly given the more active balance sheet QT scheduled for next month, which may give rise to liquidity pressure. We think that headline inflation will continue to trend lower, although geopolitical events and climate conditions could alter the trajectory, and while the U.S. economy is slowing, the pace remains behind the more debilitating course in much of Europe. A more hawkish posture is now being telegraphed by global Central Banks, with a key ECB policymaker positing that stronger tightening is needed even if the European economy sinks into recession. Against this backdrop, bond market activity is likely to remain volatile with exposure to sharp movements. We think that investment opportunities will present themselves at higher yield levels before an eventual easing policy bias takes hold. We maintain that there may very well be a stronger tone for munis as tax-efficiency and a flight-to-quality bias help to support demand for the asset class. While UST remains fully committed to curve inversion with greater punctuation, the muni curve has corrected its front-end inversion with a presently tighter flattening bias. We suspect that the muni curve could grow flatter, particularly for short tenors, as the Fed moves to more restrictive ground, yet prospects for another inversion are low given the more compelling ratios and we could expect to see some dilution in relative value for long-dated tenors throughout the tightening cycle.

The retrenchment of summer reinvestment demand throughout this month has been a major factor in the adjustment, along with the pushback against such expensive ratios. The muni market is teed up from both a technical and fundamental credit perspective to offer compelling value and at the risk of sounding like a broken record, munis deserve important consideration in a defensive asset allocation strategy designed to weather the effects of an economic downturn. Muni issuers have generally bolstered their balance sheets and overall reserve balances and have engaged in more conservative debt management practices. Municipal enterprise operations have been improving since the onset of COVID and for many, coverage ratios have been strong enough to preserve rating assignments.

For a comprehensive portfolio evaluation of your municipal holdings, please contact your Oppenheimer Financial Professional.