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Fed 25 Basis Point Rate Hike Reflects Bank Concerns…The Fed has likely moved closer to the end of its rate hike cycle, as it seeks to hold rates high this year. The collapse of a few banks has led the Fed to change its guidance from ‘ongoing rate hikes’ to ‘some additional hikes.’ Last week, the Fed raised policy rates by 25 basis points last to a target range of 4.75% to 5%. Central bankers even considered pausing rates last week because tighter credit conditions are expected due to the recent banking system turmoil. “Such a tightening in financial conditions would work in the same direction as rate tightening. In principle, as a matter of fact, you can think of it as being the equivalent of a rate hike or perhaps more than that,” Powell explained. Just two weeks ago, Fed officials were planning to increase the pace of rate hikes based on stronger-than-expected jobs, spending, and inflation. That has changed. Now, the Fed will closely monitor credit conditions for households and businesses, as tighter credit conditions may offset the need for more rate hikes. The fed-funds rate could peak at 5.1% this year per Fed projections, unchanged from its December forecast, overturning prior expectations of an upward revision. The Fed envisions rate cuts next year could bring the fed-funds rate to 4.3% by the end of 2024.
Lower Growth Outlook…Risks to economic growth are weighted to the downside, nearly all Federal Reserve members agree. Slower economic growth could be an outcome of tighter credit conditions for households and businesses, a result of banking system turmoil. The Fed expects subdued growth of 0.4% this year, and 1.2% next year, well below the longer-run normal growth rate. Last year, the economy grew at a below-trend pace of 0.9%. Consumer spending picked up in the first quarter, as did employment levels. The Fed expects unemployment to rise to 4.5% by year-end, from 3.6% currently. “Inflation has moderated somewhat since the middle of the last year, but the strength of these recent readings indicates that inflation pressures continue to run high,” Fed Chair Powell noted. However, housing prices, which make up 44% of the Fed-preferred inflation gauge, have weakened. Central bankers expect relatively slow growth, a gradual rebalancing of supply and demand in the labor market, with inflation moving down gradually.
Home Prices Drop…Median home prices are down 12.3% from June record highs. February sales of existing homes are 22.6% lower than a year ago. However, easing mortgage rates led to higher home sales in February, up 14.5% from a month ago defying consensus forecast of 5% growth. Home sales fell for twelve straight months, before picking up in February. High housing costs have made a large contributed to inflation. Lower home prices reflect the impact of the Federal Reserve’s efforts to combat inflation by raising interest rates.
Judge Rejects Puerto Rico Electric Utility Revenue Bondholder Claim… Judge Swain ruled that Puerto Rico electric utility bondholders have an unsecured claim on revenues. The Judge ruled that bondholders do not have a lien on electric utility revenues, but an unsecured claim on the utility’s future net revenue. Judge Swain ruled that monies sitting in a sinking fund, a self-insurance fund, and a reserve maintenance fund belong to bondholders. The ruling is a win for the oversight board and the Puerto Rico administration. The oversight board said it is reviewing the ruling “to determine the implications of bondholders’ remaining claim but will continue to work on resolving the remaining issue of PREPA’s debt restructuring consensually.” The parties “are further directed to commence working with the mediation team immediately in good faith efforts to resolve consensually the outstanding disputes concerning the proposed plan of adjustment,” Swain wrote.
Illinois Bonds Rally…Illinois bonds are rallying, and investors demand a smaller yield penalty for the lowest -rated U.S. state. Illinois bonds have gained 2.7% so far this year, outperforming overall municipal bond benchmarks. Illinois is now rated in the ‘A’ rating category by Moody’s and S&P, after eight credit upgrades in the past two years. Illinois general fund revenue in the current fiscal year, which ends on June 23, is expected to outperform enacted budget by 12% or $5.5 billion per, the bipartisan Commission on Government Forecasting and Accountability forecast this month. This is a turnaround from a few years ago when fears of junk-rating and revenue downturn led investors to demand a steep yield penalty for Illinois general obligation bonds. Today, Illinois bonds fetch about 110 basis points more than top-rated municipal bond benchmarks, reflecting higher investor confidence. Illinois’ $1.5 billion general obligation bond sale, expected in the second quarter, is eagerly awaited by investors seeking yield from an improving credit.
States and Local Governments’ Diversified Banking Relationships…Municipal bond issuers manage many banking relationships conservatively and in a diversified manner. This includes debt underwriting, credit lines, trustee and cash accounts. Diversification lowers risk, and lowers exposure to any single institution. Since 2008, states and local governments have lowered use of short-term variable rate demand bonds, which are remarketed by banks on a weekly basis, reducing exposure to the banking sector. However, direct bank loans have gained popularity with states and local governments. Faced with tighter credit conditions, states and locals are likely to keep an eye on renewal terms for short-term bank loans. The Federal Reserve’s emergency lending facility for U.S. banks should help mitigate liquidity pressures and shore up the banking system. U.S. Treasury Secretary Janet Yellen said last week, “Certainly, we would be prepared to take additional actions if warranted.”
Low Municipal Bond Supply Continues…Tax season as well as uncertainty from the banking sector tumult has curbed state and local government borrowing plans. Visible supply, or the amount of municipal bonds expected over the next 30 days, dipped to the lowest in a month. More clarity on the economic environment and Federal Reserve policy in the wake of the collapse of a few banks are front and center. Typically, bond issuance dips when Fed announcements loom. States and locals avoid selling bonds during tax season, a time when hefty tax bills lead many wealthy investors to sell bonds. So far this year, municipal bond supply is the lowest since 2018.
Compare 30-Year taxable U.S. Treasury yield 3.71% to 30-Year tax-exempt Municipal Bond yield “AAA” 3.46%; “AA” 3.79%; “A” 4.32%. 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 93% of comparable taxable U.S. Treasuries.