Central Bank Redemption?

The Fed is not perfect and prior criticisms may be valid, particularly the Central Bank’s commitment to a zero-interest rate policy for perhaps too long. Having said this, we have been supportive of the Fed’s actions to date designed to slow economic growth and drive inflation down to target. Given the absence of a policy meeting in August, there will be an active runway of Fed-speak until the next “blackout” period commences ahead of the September 19-20 gathering. Our own forecast has been recently revised stronger from a “braced” to a “softish” landing, but this assumes monetary policy success without any substantive missteps, ongoing economic strength, modest impact from a resumption of student loan payments this fall, and a manageable credit contraction with sustained banking sector prowess. The overall combination of variables with or without banking conditions could produce a potentially different outcome having a more difficult landing. Suffice it to say, recession should retain its rightful place in the conversation as no one scenario should be set in stone and the potential for fiscal drag has not disappeared. Taken in totality, the economic data points illustrate more observable disinflationary conditions against a backdrop of consumer (let’s point out stronger-than-anticipated July retail sales) and labor market resiliency with overall growth yet to concede recession. In our view, monetary policy is now at a crossroads with the Fed’s 2% inflation target, while closer in reach than it was this time last year, at the center of contention. A growing number of market participants favor the current trajectory and do not want to see the economic momentum derailed by a policy error. The more hawkish observers, however, are concerned with the prospects of re-emerging inflationary pressure with the potential for higher goods prices at a time when stakeholders are holding out hope for inflation across the services sector to exhibit signs of easing. As we approach the September FOMC meeting, we are likely to see divergent sentiment, a rational evolution given the nearing conclusion of the Fed’s tightening campaign, with a number of folks responding “yes” to that proverbial question, “Are we there yet?”

Should oil remain under pressure, a decision by the Biden administration to again tap into strategic petroleum reserves may see meaningful push-back and any likelihood of additional output from OPEC remains uncertain. Recent indications of China’s fiscal and economic woes could yield implications for global energy demand, thus potentially alleviating upward price pressure on oil. Perhaps if we can stay the course, we could envision a pause in September, and potentially through the balance of the year, which would dovetail nicely with our expectations for a soft-ish landing. However, we can expect continued volatility with respect to food and energy prices over the near-term, with an overall upward bias for commodity costs a possibility. Labor market conditions continue to cool with a downward trend in job formation and moderating growth in wages even though the overall employment sector remains strong. We suspect that when policymakers gather later this month in Jackson Hole, Wyoming for the annual Kansas City Fed-sponsored economic symposium, Chair Powell will likely keep the Fed’s options on the table as he will remain committed to the 2% target and not signal “mission accomplished” just yet, particularly as additional slack is required in the labor market in order for the Central Bank to meet its goal.

The latest tour of the 10-year Treasury benchmark yield above 4% may, in part, be due to some collateral damage following Fitch’s downgrade on U.S. sovereign debt from “AAA” to “AA+” with a growing focus (for now) on things like debt to GDP and unsustainable interest carry on our nation’s debt, but may also reflect supply pressure and all-too-familiar geopolitical concerns, not the least of which is looming changes to Chinese fiscal policy and the Bank of Japan’s departure from yield curve control. The September FOMC will be accompanied by a revised summary of economic projections and we can assume a more sanguine view of growth expectations even as job formation is slowing, bringing labor supply/demand closer to equilibrium. While there may be an expanding chorus in favor of holding rates steady, the devil will be in the data details and we will be seeing quite a bit more throughout the remainder of the summer. Just ahead of press time, contracts were flashing a more hawkish outlook for rate policy as the wager assigns close to a 30% probability of a 25-basis point hike at the November meeting versus a 21% likelihood at the beginning of August. Chances of a 25-basis point bump in September has dropped from 17% at the beginning of the month to 11% as of this writing. August, month-to-date, has seen its share of bond market volatility with the UST ten-year perched above 4% longer than we expected as the bond market seems to be pricing out recession (at least for now), attaining its highest level since last October. However, we believe that much of the conditions keeping yields elevated appear to be transitory in nature and we expect rates to migrate lower over the near-term, driven by ebbing supply pressure on the heels of surprisingly efficient and well-placed Treasury auctions, greater acceptance of the newly-assigned U.S sovereign rating from Fitch, expanding comfort with the resiliency of our national economy, and what may turn out to be a flight-to-quality bid amid developing geopolitical events and circumstances. While we cannot rule out lingering Treasury rate volatility throughout the balance of the year, UST yields may find themselves range-bound until conviction takes hold and presses them lower.

While August is so far posting negative returns across fixed-income cohorts, municipal bonds are displaying out-performance, both on an absolute and tax-adjusted basis, thanks largely to constructive market technicals and the resiliency of overall demand for product against a summer backdrop of negative net supply. It appears that an extended cycle of mutual fund outflows has been broken as the improved market tone has paved the way for intermittent weekly inflows. In our view, a cyclical return to positive flows would require rate stability, further evidence of disinflation, and continued technical support. It is this out-performance that has kept tax-exempts more expensive relative to Treasury alternatives. Looking at index attribution, the yield income or what is more commonly referred to as “coupon carry” has been the primary contributor to YTD performance as opposed to principal appreciation. Given the tax-efficient and credit attributes along with the current yield benefits, investment in municipal securities helps to offset the impact of rate volatility and to maximize the potential for long-term total return. With the 2018 income tax cuts sunsetting in 2025, the value of tax-exemption on munis can be expected to become more pronounced. The Fed may very well be at the end of its tightening campaign, yet the Central Bank is, overall, likely to remain more hawkish than will market expectations. If we had to make a decision right now based upon the data, there is ample justification for a pause at the September meeting. This does not necessarily mean to say, however, that additional restrictive policy cannot be deployed. In a near-perfect scenario, the economy slows without falling into recession and the Fed moves even closer to its 2% target, with perhaps something a bit higher offering an acceptable compromise. This would likely set the stage for a bull-steepening UST yield curve, but there would have to be broader consensus that the tightening cycle has concluded. Munis may find themselves under-performing should this scenario come to fruition as an extended UST rally ensues, but if the supply/demand imbalance persists within the muni market, tax-exempts could break free from the Treasury market’s grip and follow its own performance trajectory. Munis should continue to find a bid as reinvestment needs hold in with out-performance likely to promote richer valuations. However, as we move beyond the summer, technicals can be expected to grow less supportive with munis finding it challenging to outperform taxable alternatives.

Investors are advised to remain nimble and to seize opportunities as they arise. Where possible, keep some powder dry and be prepared to deploy capital when appropriate. Furthermore, be able to form a more discerning view on credit and develop an appreciation for muni sector differentiation as performance trends will likely differ within the muni asset class. When conducting portfolio reviews, recognize that municipal credit has likely plateaued and given an environment of credit spread compression, it may be advisable to trade up in credit quality in preparation of the next economic downturn which may give rise to potential shocks to the portfolio. A well-disciplined review of portfolio holdings will identify trouble spots in an effort to limit credit and market price erosion and to determine whether or not existing positions continue to meet investment guidelines and suitability needs. When confronted with credit and price erosion, it is important to consider a portfolio’s appetite to harvest losses and overall portfolio diversification is important with a particular emphasis on state, local and sector diversification. Out-of-state bonds can provide diversification and many times can provide sufficient yield to offset state (and possibly local) taxes paid on these bonds and at times there could be the opportunity to capture greater overall yield on out-of-state bonds versus the available yield on in-state bonds. State General Obligation bonds are expected to remain current on debt service, however, a number of the states may not possess the fundamental attributes needed to avoid credit pressure ahead of and during the next down cycle. Unfunded pension liabilities will continue to be tethered to equity market performance and can be expected to create fiscal drag for a number of municipal governments. Local governmental credits located in more problematic states could fall under greater credit pressure if there is a heavy reliance on state support. Conversely, opportunities to invest in local credits from some of the more troubled states may be available provided that those credits are well-insulated from the vagaries of that state’s general fund budgetary process and the local credit has either a strong G.O. pledge with ample geographic diversification or a very secure revenue stream with ample debt service coverage and other protective covenants.