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Municipal Bond Outlook Boosted… Slower rate hike expectations and lower-than- forecast actual inflation has boosted the outlook for municipal bonds. Cumulative 4.25 percentage point rate hikes in 2022 are seeds for a recession, that will eventually lead to rate cuts, if not in 2023, then 2024 experts reckon. “It’s the Fed which is the cause of all this volatility,” a Citigroup strategist said “With the Fed taking a breather next year, the volatility will come down.” With bellwether 10- year U.S. Treasury bonds yielding about 3.5%, down from a multi-year peak of above 4% in early November, municipal bonds have gained 5.4% since November. With the majority of central bank rate hikes in the rearview, bond investors are putting the worst year in a generation behind them.
Consumer Price Gains Moderate… November consumer prices rose at the slowest pace in a year. Price gains have moderated since the summer. Consumer prices peaked in June, with a 9.1% CPI reading. November CPI index climbed 7.1% from a year ago, down sharply from 7.7% in October. Core CPI, which excludes volatile food and energy prices, rose 6% in November from a year ago, lower than October’s 6.3% gain. September’s 6.6% Core CPI gain was the biggest annual jump since August 1982. On a month-to-month basis, CPI rose 0.1% in November, down from 0.3% in October and 0.6% in August and September. November price gains are lower than consensus forecasts. Although price gains are well above the 2.1% average reading in pre-COVID-19 years, a trend of moderating price increases has begun.
Peak Policy Rate Estimates… Bond markets expect some rate cuts in 2023. In contrast, no fed official has projected a rate cut next year. Fed officials expect policy rates to move down to 4.1% only in 2024. A terminal fed-funds rate between 5.1% to 5.25% will be enough to cool prices, Fed officials raised their prior 4.6% median estimate However, fed-fund futures prices suggest a lower terminal rate of 4.87%. No one was surprised that the Fed hiked rates by 50 basis points last week to a target range of 4.25%-4.50%, after four consecutive 75-basis rate hikes this year. The Fed signaled plans to lift rates higher through middle of next year, likely in smaller increments.
Inflation Forecasts… There is consensus that price surges will be lower next year. However, inflation predictions vary. UBS expects U.S. inflation to be “close enough” to the Fed’s 2% target by the end of 2023, and Goldman Sachs expects headline CPI to be 3.2% by mid-2023. J.P. Morgan’s call for January headline CPI is 5%. Bank of America’s March-23 headline price gains forecast is 4.4%. Meanwhile, the Fed raised its expectations for core inflation to be 3.5% next year, higher than its 3.1 % prior estimate. After the Federal Reserve took much flak for stating inflation to be transitory a year ago, its’ projections have become more pessimistic. Noted economist and former U.S. Treasury Secretary Lawrence Summers said, ‘For now though, the economy appears stronger and inflation and inflation expectations a bit lower than I would have guessed a few months back. This is good news and a tribute to a determined Federal Reserve action.” Average annual inflation of around 2.15% over the next decade is implied by Treasury Inflation Protected bond prices.
Fed Steadfast in Inflation Fight… San Francisco Fed president Mary Daly stressed that the Fed still had a “long way to go” before declaring victory on inflation and said the risks are still tilted to the “upside” in terms of further price pressures. Cleveland Fed President Loretta Mester said there are only “tentative” signs to date that inflation is beginning to stabilize. She said she needed to see “cumulative evidence” before feeling more confident price pressures are moderating. Fed officials have acknowledged that getting inflation under control will require a sustained period of low growth and higher unemployment.
Slower Growth Ahead… GDP forecasts for 2023 are gloomy. The Fed sees economic growth of just 0.5% next year, down sharply from September’s 1.2% projection and consistent with a recession. It sees unemployment climbing to 4.6% from 3.7% now, higher than projected in September. Economists surveyed by WSJ assigned 63% odds of recession in 2023, up from near-even odds in July, with GDP expected to shrink at a 0.2% annual rate in first quarter of 2023, followed by a 0.1% contraction in the second quarter. 2022 GDP growth is expected to be near 2%.
Puerto Rico Electric Utility Plan Filed… PREPA’s debt adjustment plan was filed in the Title III court on Saturday. The Ad Hoc Group of bondholders and most bond insurers are not onboard with the plan proposed by the oversight board. The oversight board is open to continuing debt talks with bondholders. Pending litigation on PREPA revenue lien granted to bondholders will determine whether bondholders are entitled to PREPA future revenue or limited to bond debt service accounts holding $16 million. The board’s plan proposes a minimum 50% recovery to legacy bondholders who drop the lien litigation. Non- settling bondholders’ recovery will depend on the outcome of the lien litigation. Settling bondholders will receive new 6% coupon long-term bonds and a contingent value instrument. New PREPA bonds will be paid by a flat connection fee and volumetric charge added on Islander’s electric bill. “I voted against the Plan of Adjustment filed by the Oversight Board because I believe it treated bondholders unfairly, and because I believe it was predicated on financial analysis produced to solve for a desired outcome – to pay as little as possible. The Oversight Board’s unilateral approach to mediation was disappointing. It prevented a global deal with all bondholders that was within reach,” oversight board member Justin Petersen vowed to oppose the debt plan. “The Plan we filed today is a big step forward, but it is not the last step. We will continue to negotiate with creditors on the path to confirmation of the Plan by the Court,” said oversight board chair David Skeel suggesting the proposed plan is the board’s opening salvo.
Compare 30-Year taxable U.S. Treasury yield 3.62% to 30-Year tax-exempt muni bond yield “AAA” 3.47%; “AA” 4.04%; “A” 4.58%. For investors in the 35% tax-bracket, a 4% tax-exempt yield is equivalent to a 6.15% taxable yield. Top rated long-term tax-free bonds yield 96% of comparable taxable U.S. Treasuries.