Waitin' on a Sunny Day - A Bruce Springsteen Tribute

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As we sat down to craft this week’s commentary, an unresolved debt ceiling debate, conflicting Fed-speak, and still-unsettled banking event risk had sparked a wave of volatility throughout the financial markets that make it seem like Jungleland or perhaps Darkness on the Edge of Town. The FOMC meets June 13/14, and we have Reason to Believe that there will be more active consideration of a pause than what was contemplated during the May gathering. The traditional “blackout period” begins June 3rd and so there is still ample time to receive and digest further Fed-speak. Current inflationary pressure is clearly Tougher Than the Rest with some rather pronounced areas of stickiness, and while we are still a long way from The Promised Land of 2%, we have adopted a Take ‘Em as They Come attitude towards rate hikes as Chair Powell and team show No Surrender in their fight against inflation. Although expectations for a June pause have receded from a week ago and bounce up and down depending upon the policy wind of the moment, the wager being placed with the futures contracts continues to reflect a suspension in the Fed’s tightening cycle with a Hungry Heart of rate cuts expected to come later this year. When Chair Powell convenes his post-FOMC press conference on June 14th, it may be a Lonesome Day even though he may be thinking to himself I’m on Fire as it will be up to him to convey an acceptable message regardless of whether the Central bank pauses or puts through another 25-basis point rate increase. Mr. Powell has demonstrated his avoidance of being Trapped by his inquisitors and will likely make every effort to Prove It All Night that he and his Central Bank Brethren are committed to The Promise of price stability.

We should position ourselves for a June pause with the understanding that subsequent data could move rates higher for a while longer and that the Fed should not Shut Out the Light on more restrictive territory. While The River of Fed-speak since the conclusion of the early-May FOMC meeting has been quite active, let’s keep in mind that not all policymakers have the vote this year. Many are often expressing their individual, “My Hometown” views apart from a group setting, that often tie back to the specific performance of one of the twelve Federal Reserve Districts if a regional bank president is providing the commentary. We also have to acknowledge the fact that despite diverging opinions, the final policy vote is usually unanimous, and we can be sure that the Chair exerts his influence on The Ties That Bind. We have consistently pointed out The Rising presence of multiple headwinds, not the least of which are the recent bank failures and the prospects for more with the attendant tightening of credit conditions, that could meaningfully impact employment, inflation, consumer sentiment, and overall economic growth like a Spirit in the Night. Movement closer to flattish growth, even after an upward revision to Q1 GDP from 1.1% to 1.3%, can be expected, and we will continue to focus on evolving conditions that could signal a contractionary scenario. Mid-week, we received the minutes from the May 2/3 FOMC meeting and there was clear division among the ranks in terms of the need for further rate hikes beyond the last 25-basis point bump. Lost in the Flood of words, we found that “some” officials supported additional tightening, while “several” thought policy had reached sufficiently restrictive ground and that further rate increases were not necessary.“Many participants focused on the need to retain optionality” according to the minutes. Given that Fed staffers project a mild recession to commence later this year, contrary to Chair Powell’s view that recession could be avoided, the June meeting will come with a revised summary of economic projections with the Dot Plot shining through the Light of Day, giving stakeholders the opportunity to gauge policymakers’ fresh thinking on the economy, even at Night. Some” participants suggested that further tightening could be necessary should inflation display an unacceptably slow trajectory down to 2% with most signaling upside risks to the inflation outlook. A number of policymakers expressed concern over the looming debt ceiling debate and how an untimely resolution could impact the financial system. There was also a general sense that tighter lending practices, while certainly not a Wrecking Ball, could impede economic advancement.

Bond yields assumed an upward path through much of May thanks to the uncertain prospects of another rate hike and the unsettled debt ceiling debate. For example, benchmark 10 and 30-year UST yields are presently up 33 and 26 basis points respectively since May 3rd. Noted advances on ultra-short Treasury tenors are largely attributable to greater uncertainty tied to the debt ceiling impasse. Similar maturity muni yields have advanced 34 and 23 basis points respectively during the same time period, signaling that tax-exempt investors are not Worlds Apart from the market forces driving bond yields higher. A default on U.S. Treasury debt would have rather pronounced implications for the municipal securities market, sending volume forecasts Into the Fire and raising numerous credit concerns across multiple sectors. Elevated uncertainty and volatility often lead to issuer hesitation and with a looming FOMC meeting coupled with the debt ceiling concerns, we would not be surprised to see more day-to-day wait-and-see activity, as issuers Drift Away and pull primary supply below recently heavier weekly volume, a potentially constructive development for the muni market. The back-up in muni yields has pushed relative value ratios to their cheapest levels for the year. The two, three, five, and ten-year ratios are all well over 70% with the 30-year benchmark now standing at 92% as cuts along the muni curve have been particularly consistent this week. Better Days are in store for munis. While the debt ceiling impasse has factored into rising yields, resolution will come and once the June FOMC concludes, market technicals will likely become the driving force. Bloomberg presently reports a net negative supply of $16.79 billion over the next 30 days, with even deeper supply deficits anticipated for the following two months. With this expected technical shift, municipal bond mutual fund flows may be able to Follow That Dream into more positive territory and the well-tested attributes of strong credit quality, diversification and tax efficiency should guide investor preferences.

Higher cash flow is again available in fixed income, with munis saying If I Should Fall Behind, then even better entry points can be obtained. Such expectations dovetail nicely with our defensive narrative ahead of multiple event risks, including prospects for recession. With elevated absolute yields and cheaper ratios, investors are advised to extend allocations into munis as tax-efficiency and other attributes drive the process. Better technicals could direct ratios back to richer levels and so the window of opportunity to lock in better terms may hit The Wall soon. If volatility can manage to abate, this can open up possibilities to see meaningful conviction on the flow side as we hope that a cycle of net withdrawals Fade Away. Although cash alternatives seem rather enticing today, it may be easy to be Blinded by the Light and potentially give up longer term investment opportunities provided by compelling yield levels. Month-to-date, munis and UST are in the red, with tax-exempts outperforming. As we have often noted, munis tend to underperform a bond market rally, and outperform a sell-off. Should bets on a 2023 rate cut recede, there could be weakness along short-tenor Treasuries. If overall bond yields move higher, munis can be expected to outperform with the constructive technicals in place over the next few months. Admittedly, munis have been experiencing some Restless Nights of late, and while the Treasury market softness is certainly having its contagion affect, heavier supply has given rise to underwriter challenges and both retail and institutional demand has yet to Come Out Tonight in full swing given the less compelling ratios for much of the year and the unusual muni curve inversions. As mentioned, however, constructive technicals may not show munis Rockin’ All Over the World, but it will be far from an Empty Sky with demand, flows and performance all posturing for improvement. Outflows throughout this year are still eclipsed by the record fund withdrawals of 2022, and credit, although peaked, is expected to remain largely resilient before, during, and after the next recession. While security selection within a particular sector is key to defensive investment, allocations into state and local governments, school districts, airports, Working on the Highway toll roads, and bulge bracket health care and higher education credits having robust balance sheets, clearly defined mission statements, strong market presence, and sound operating performance can help to create a well-diversified and defensive portfolio Born in the USA.