Muni Performance Leading Into The Ides Of March

Messaging from Chair Powell and team acknowledges a likely pivot in 2024, but quite frankly the onset of a rate cut sequence appears to be on the Central Bank’s time. While CPI came in somewhat hotter than anticipated, there was little impact on futures pricing for a rate cut this month given that the bar was set extremely low at about 5% prior to the CPI release, and dropped even lower to under 1% following the print. Although core goods pricing was modestly positive for the first time in nine months, core services inflation somewhat ebbed given a slowdown in owners’ equivalent rent. Should shelter expenses continue to moderate, we can expect to see attendant disinflationary reaction in subsequent CPI prints given their meaningful contributions to this data point. Thursday’s release of February PPI extended the stubbornly hotter run of inflation with elevated fuel and food costs, driving the headline number month-over-month and year-over-year and adding to the mix of opposing data signals, which only adds to the Central Bank’s conundrum. Core wholesale prices, both on a month-over-month and year-over-year basis, modestly exceeded consensus with components of the overall PPI being fully vetted as a view into the much-anticipated February PCE report scheduled for release on March 29th, with the deflator expected to soften through June. To round out the week’s top economic reports, February retail sales were below expectations despite more favorable weather conditions pointing to better activity, and brought into question the future resiliency of consumer spending. We suspect that consumer preferences are likely to become more visibly selective as the labor backdrop continues to soften and financial conditions grow tighter. While the consumer will continue to keep GDP within positive, albeit modest, territory, we would not be surprised to see more retrenchment throughout the year with chances of a re-accelerating economy not a high probability and a “softish landing” still central to our base case.  

Admittedly, there remains some stickiness to inflation, yet we believe that overall inflation is experiencing some pain as the disinflationary trajectory seeks equilibrium, thus detracting from the Fed’s desired confidence that inflation is moving down to target. We must agree with Chair Powell and team when they say policy will be guided by the flow of information, but we believe that the primary determinant will derive from the inflation inputs with the labor data not as impactful. Collectively, this round of data points should be viewed as neither alarming nor determinants of monetary policy for the upcoming FOMC meeting as it fails to deliver conclusive directional evidence of where inflation is heading. When the Fed gathers, it is a foregone conclusion that it will hold the range for the benchmark funds rate at 5.25% - 5.5%, leaving policy steady for the fifth consecutive meeting. As of this writing, the first best chance of a rate cut could arrive with the June FOMC meeting, with a September wager heavily priced in. Let’s also accept the notion that the easing cycle does not necessarily have to be on a consecutive basis, with an interim pause certainly on the table. At a point in time determined by the Fed, The Quantitative Tightening (QT) campaign will likely be adjusted as the current schedule is not sustainable. Thus, we expect to hear more about QT and efforts to slow its runoff rate during Chair Powell’s post-meeting press conference. Importantly, the policy meeting comes with a revised summary of economic projections (SEP), and market stakeholders will likely focus on the “dot-plots”, although there may be little revelations for when the Fed may initiate its easing cycle. The challenge is to normalize policy while not sacrificing economic standing, translating to a “softish landing”. 

From the September to the December SEP, the median “dot-plot” for the 2024 funds rate showed a reduction of 50-basis points, with December’s target range set between 3.9% - 5.4% and overall cuts totaling 75-basis points for 2024. Although initially projecting 7 or 8 25-basis point cuts this year, futures contracts are now aligned with the Fed’s December thinking. With the Fed’s aggressive tightening campaign to tackle the highest inflation in forty years, asset allocation strategies shifted in favor of money market funds and other short-term investment vehicles as curve inversion drove the investment narrative. As the mind-set pivots to an easing cycle, asset allocations are once again seeking new guidance, particularly with estimates of $6 trillion of sidelined cash awaiting deployment.  The extended duration trade has been a beneficiary, albeit not consistently, of anticipated lower rates, a scenario that was not the case throughout the rate hikes of 2022 where long dated tenors witnessed punishing valuations. 

Month-to-date, munis have struggled to outperform Treasuries, yet the asset class managed to find its footing thanks to constructive technicals. MTD, munis are returning 36-basis points, versus a 16-basis point deficit for UST. YTD, munis are down 2-basis points, while Treasuries are losing 1.74%. It would appear that the intermittent period of positive mutual fund flows that we have been talking about has arrived. Year-to-date, net flows have been positive for the third consecutive week with 10 consecutive weeks of high yield inflows. Issuance was strong in January and February, driving new-issue supply higher by 35% Y/Y, and was met with heavy pent-up demand against a backdrop of a relatively stable muni rate environment. March MTD returns, as noted, are respectable as demand outstrips supply. Having said this, the balance of March may continue to be better-than-expected, particularly given existing demand and decent reinvestment needs over the next 30 days. 

There is no denying available cash flow opportunities in the muni market and investors are advised to take advantage of market weakness. We can expect fund flows to remain intermittently positive given that lower rates are on the horizon and that the extended duration trade could offer value. In the primary market, deals are being priced with very low spreads and many are being oversubscribed. It is this supply/demand imbalance that seems to shift some of the focus away from the frothy ratios tethered to the 2024 muni market, and as noted in our last Basis Points, SMA accounts are generally more fixated on quality portfolio construction than on relative value. Should rate volatility appreciably emerge, we could see visible cheapening in ratios with potentially compelling entry points.  As previously noted, selling pressure to cover April tax liabilities could also help to cheapen muni bond prices, thus creating opportunities before the onset of reduced summer supply.