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Week of 3/21/2022
25 Basis Point Fed Funds Rate Hike… Can The Federal Reserve Fight Inflation… Bond Market Signals Contradict Fed Dot Plot…Bets on Recession, Stagflation…Growth Prospects Downgraded… Detroit Wins Second Upgrade…
25 Basis Point Fed Funds Rate Hike… Federal Reserve officials voted 8-1 to lift the federal funds rate to a target range of 0.25% to 0.5%, the first increase since 2018, after two years of holding borrowing costs near zero. Fed officials’ median forecast for the federal funds rate is 1.9% at the end of 2022, and 2.8% at the end of 2023 and 2024, steeper than previous Fed estimates. The Fed will outline its balance sheet reduction plan at an upcoming meeting. St. Louis Fed President James Bullard, who dissented seeking a half- point hike and implementing a balance sheet reduction plan this week, said that he favored raising rates above 3% this year, identifying himself as the lone high dot. Federal Reserve Governor Christopher Waller said the war in Ukraine was the reason he didn’t push for a half-point increase at the meeting, but that was definitely on the table for upcoming meetings. “The data is basically screaming at us to go 50, but the geopolitical events were telling you to go forward with caution. So those two factors combined pushed me to support the 25 basis point rate hike.” Last week Powell said there are “seven remaining meetings, and there’s seven rate hikes.”
Can The Federal Reserve Fight Inflation… The Federal Reserve’s predicament is that aggressive rate hikes could cause a recession now, but not taming inflation could cause a recession later. The Fed anticipates inflation of 2.7% in 2023 and 2.3% in 2024, up from earlier forecasts, but below an anticipated 4.3% in 2022. The Fed’s preferred inflation gauge, the personal consumption expenses deflator was at 5.4% in the 12 months through January. Prices of Treasury-inflated protected securities see inflation at about 3.5% over the next five years, the highest since January 2003. Going back in history, draconian policies enacted by Volcker Fed to fight inflation in the late 1970s/early 1980s brought back-to-back recessions in 1980-82. In recent monetary cycles, whenever equity prices have fallen 20% or 30% since the 1990s, it turns out to be a “reaction point” and central bank policy pivots to support markets. Seldom stated as an outright goal, but financial markets have not been ignored by central bankers in recent years.
Bond Market Signals Contradict Fed Dot Plot… Some of the Federal Reserve’s agenda of tightening financial conditions is being done implicitly by financial markets. “The volatility in financial markets, particularly if sustained, could also act to tighten credit conditions and affect the real economy,” Fed Chair Powell stated last week. Amid geopolitical events, the Federal Reserve’s interest rate hikes and a reduction in bond holdings will present a “double whammy” for the economy that bond expert Jeffrey Gundlach expects to begin soon. “It’s a really bad bet to count on the Fed engineering a soft landing in this kind of environment with the curve partially inverted,” Gundlach said. However, Fed Chair Powell thinks otherwise as he stated, “the probability of recession within the next year is not particularly elevated.” Powell termed the U.S. economy incredibly strong with its robust labor market. Historically, oil shocks have cut demand and triggered recessions. Oil prices rose to $139 a barrel before sliding down to $100 a barrel recently, compared to about $90 a barrel a month ago. Recession indicators, like the narrowing spread between two-year and 10-year Treasury’s, are beginning to surface. “Once you are at 25 basis points,” it represents a recession watch, and yesterday that spread reached 15 basis points”, Gundlach noted. In the past, unforeseen events have led the Fed to change its view on monetary policy. Bond investors do not put a lot of stock into projections beyond the current year. Investors are skeptical that the Fed can hike rates aggressively without upending the economy.
Bets on Recession, Stagflation… “The odds are much better than even that we actually do experience a recession in that scenario,” a Moody’s Analytics economist said that an extended Russia-Ukraine conflict could hit the U.S. economy. The impact could vary across U.S. states. New York, Connecticut and California are likely to be feel the impact of financial markets’ volatility, while sanctions related supply chain constraints could affect Michigan’s automobile-centered economy and there could be fewer buyers for Florida’s pricey real estate. Energy-rich states could fare well with higher gas prices and agriculture-based states would mostly benefit from higher commodity prices. In the 70s, the U.S. economy suffered a period of recessions and stagflation during the oil embargoes of the 1970s. However, today food and energy costs take up a much smaller portion of a consumer’s budget, compared to then, and the U.S. has made strides towards being self-sufficient by diversifying fuel sources. The wake of the Russia-Ukraine war has left price shocks in commodities and food and potential for wider conflicts or cyberattacks bring security challenges, heightening uncertainty for U.S. economic growth.
Growth Prospects Downgraded… The Fed cut its forecast for 2022 GDP growth this year to 2.8%, down from 4%, and economic growth could drop to 2.2% in 2023 and 2% in 2024. Goldman Sachs economists predict that the U.S. economy could grow at a pace of 1.75% in 2022, down from 2% forecast earlier. The U.S. economy grew at a robust 5.8 percent pace last year. Growth in U.S. retail sales slowed in February after surging a month earlier, suggesting that consumers tempered their spending faced with high gas prices. February existing home sales are lower and recent mortgage applications fell sharply from prior readings. Despite high employment, consumer sentiment is sour, down to the lowest level since 2011, the University of Michigan reported recently. Faced with China’s recent shutdowns to curb a new COVID-19 wave and major geopolitical events, the Federal Reserve said implications for the U.S. economy are “highly uncertain”, but in the near term, upward pressure on inflation and growth concerns are front and center.
Detroit Wins Second Upgrade… S&P upgraded Detroit’s credit rating to ‘BB’ on the heels of Moody’s positive rating action. S&P also lifted the rating of Detroit debt secured by income tax revenue to investment grade. Echoing optimism, S&P said, “Detroit remains, in our view, on a trajectory to meet increasing pension costs in the near and long term within a balanced budget framework, and if it does so, we could raise the rating.” The upgrades affirms “the efforts taken to improve the city’s general obligation credit” and return “an important segment of our portfolio to investment grade,” Detroit’s chief financial officer stated. Significant rainy day reserve funding includes $30 million in Fiscal 23, to be followed by another $20 million through 2025 that could shore up Detroit’s reserves to 12% of city budget, closer to the 15% reserve funding goal. With hopes that it will help lift the junk-rated city’s credit rating, higher pension funding is also in the Mayor’s Fiscal 23 budget proposal. Mayor Duggan noted “We are going to be to an investment grade rating within a few years which I have to tell you in bankruptcy nobody believed that would ever be possible.”
Compare 30-Year taxable U.S. Treasury yield 2.47% to 30-Year tax-exempt muni bond yield “AAA” 2.39%; “AA” 2.78%; “A” 2.97%; “BBB” 3.64%. For investors in the 35% tax-bracket, a 3.64% tax-exempt yield is equivalent to a 5.6% taxable yield. Top rated tax-free bonds yield 97% of comparable taxable U.S. Treasuries.