Munis End February with Positive Performance Thanks to Technicals

Following the release of January’s above-consensus inflation data, the bond markets sat quietly awaiting the minutes of the January FOMC meeting. Although this very detailed record of the preceding policy session is typically not a front-line market mover, it can set the tone and even anticipated guidance for the next gathering. Leading up to the minutes, contracts pricing made it clear that a March rate cut was effectively off the table with the odds of a pivot to an easing bias this month at 2% as policymakers remained concerned over the inflationary path, with the present bet now bouncing around the 5% range. The minutes showed that members were cautious against easing too quickly, thus signaling a patient stance on rate cut expectations. For now, May does not appear to hold a rate cut, but June could be the appropriate time should the data remain pointed in this direction. We would, however, posit that the sequence of ongoing data, with a heavy focus on growth and inflationary performance, will determine the timing and depth of the eventual easing cycle.  As we see it, market sentiment will likely track economic outliers over policymaker projections over the coming weeks and months. If we observe nothing else, we can say that Treasury prices will remain tethered to such outliers until such time when policy conviction guides rates to a stabilized posture. Curve bias should continue inverted, at least until the rate cut cycle begins, yet with the recession narrative dissipating along with higher-for-longer expectations, market technicians will be on the lookout for signs of an elusive steepener trade should inflationary concerns hold firm. The release of January’s core PCE showed the Fed’s preferred barometer on inflation coming in at consensus, with respective increases of 0.4% M/M and 2.8% Y/Y. Similar to the outsized CPI print, pricing pressure across the services sector accounted for the boost in PCE, with goods pricing down M/M and Y/Y. Although PCE stands above the Fed’s 2% target, the particulars of the report demonstrate a lack of broad range price advances. The markets seemingly took this latest data point in stride with little movement in UST yields, and more importantly there was no meaningful changes in the Fed funds futures. All in all, the PCE report supports the Fed’s patient stance in regards to a rate cut cycle. 

Given our view of economic conditions, we must be in the camp that takes a cautious view of over-zealous easing, while at the same time looking for the appropriate entry point for a pivot. If the Fed does not get the sequence right, the impact upon individuals and businesses could be extremely negative. Having said this, we are optimistic that the Fed will successfully navigate the rough terrain and bring about a softish-landing. We continue to believe that the Fed will remain above the political drama and take the prudent steps needed to engineer the best possible landing scenario. Complicating the mission, of course, is still sticky inflation against a resilient economic backdrop with tapering chances of recession. For now, the anticipated number of rate cuts for the year appears to align with the Fed’s December median forecast contained in the summary of economic projections. As we move closer to the March FOMC, UST yields should continue range-bound, unless a subsequent data point or two signals super-hot inflation, potentially sending the 10-year benchmark to 4.5% or higher.

In the muni world, technicals continue to drive sentiment and direction, steering the asset class to outperform UST and corporate securities. Since the beginning of the year, muni supply is up about 20% Y/Y thanks to an active January which kept the conventional “January Effect” from taking form, with February volume, although lighter, also higher Y/Y. During this time, however, demand lagged in January, but picked up last month. We may see heavier sidelined issuance ahead of the November General Election, and the election outcome could influence year-end volume activity. We also note that thinly stocked dealer inventories and a general lack of secondary paper have helped to temper muni market volatility relative to other fixed income cohorts. The better returns have prevailed despite the frothy price levels offered by tax-exempts. The AAA 10 and 30-year benchmark relative value ratios currently stand at 58% and 82% respectively, a long way from the averages since 1981 with the 10 and 30-year ratios approximating 90% and 100% respectively, yet the 10-year has recently broken through richer terrain. Shorter-end investing by SMAs has extended into 2024, thus holding shorter ratios at richer levels. With the uncertainty of monetary policy, duration extensions made to capture the value trade have lacked conviction and consistency. We can envision a decline in long-term rates if policy pivots to an easing cycle with the long-end poised for out-performance. Although muni price appreciation may be challenged to move higher given the expensive valuations across the curve, a material consideration that has kept many institutional buyers weary of aggressive commitments into the asset class, munis presently offer compelling cash flows, historically lower default and higher recovery rates, portfolio diversification, and, of course, tax-efficiency. For some time now, we have argued that ratios should not be the sole, or necessarily the most important, determinant of the investment calculus, and we do think that there are certain investor types that look beyond such ratios. 

Circling back to performance, munis managed to return 13 basis points in February, while UST and corporates lost 1.31% and 1.5% respectively. While all muni maturity ranges ended the month in the green, the 12-22 tenors showed the strongest performance. This partially reflects the deeper negative returns on the longer end of the curve in January and the attendant wider runway to recover performance during a stronger month. We suspect that an improved mutual fund flow tone further contributed to the somewhat longer-dated out-performance. Until the technical backdrop shifts, munis may display further out-performance, yet we think that this window of opportunity may be closing, but not for long, with the potential for curve cheapening a real possibility. March is typically a weaker month for munis as the calendar tends to expand. Furthermore, we are likely to see less reinvestment demand as Bloomberg’s net-negative supply calculation for the next 30 days has narrowed. New issue supply over this period is higher, yet still on the lower side. We expect a number of out-sized deals across multiple sectors to be well-bid and fully placed. Added selling pressure to cover April tax liabilities could also help to cheapen muni bond prices. We expect to see more institutional presence as the market becomes cheaper and relative value frees up. Currently low ratios can be tolerated by certain classes of buyers, but cross-over interest needs to be fueled by cheaper levels. The year began with strong coupon performance supported by income accruals, and while price appreciation may be more relevant this year, “carry” will likely be the largest component of performance attribution.