Week of 1/18/2022

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Recent inflation readings keep the pressure on the Federal Reserve to remove some of its policy accommodation soon. Year-over-year basis, the Consumer Price Index (CPI) was up 7% in December. Supply chain issues added 2 percentage points to year-over-year growth in the CPI in December, energy prices added 2.2 percentage points and core CPI was up 5.5% from a year ago. Fed Chair Jerome Powell said, the economy no longer ‘needs or wants’ the ‘highly accommodative’ policies that have been in place since the onset of the coronavirus crisis. U.S. consumer price growth rose at the fastest pace in almost four decades in December. Mr. Powell emphasized that inflation has been high both because consumer demand for goods has been strong and because supplies of goods and services have been seriously disrupted. In 2021, Fed officials accelerated the pace of winding down the Federal Reserve’s bond purchases. ‘Lift-off’ of the Fed’s main policy rate is now broadly expected in March. Policymakers have signaled that they may begin to shrink their bond holdings this year. The Fed could do that passively, allowing bonds to mature without reinvesting, or they could sell assets. Mr. Powell left the door open to either possibility on Tuesday. Federal Reserve Bank of Philadelphia’s Governor said he sees the Fed starting to shrink its balance sheet in ‘in late 2022 or early 2023’ after the central bank has raised its target rate sufficiently, to around 1% from near zero. Fed Governor Christopher Waller said there may be even as many as five hikes this year, depending on inflation. Speculation is rampant as JP Morgan CEO said there could be six or seven rate hikes this year, while another billionaire investor has argued for a 50 basis point rate hike in March. Financial markets are pricing in three 25 basis point increases in the target range for the fed funds rate this year, in line with the Fed’s latest dot plot. The majority of Federal Reserve officials expect three rate hikes in 2022. Shallow rate hikes are likely given secular trends.  U.S. Treasuries yield advantage relative to advanced nations will shore up U.S. bond prices. Municipal bond yields could prove to be resilient tax-free investments over the long term.

First: Yields on municipal bonds rise slower than comparable U.S. Treasury yields when rates rise; a higher yield gap or spread suggests relative value in municipal bond prices. Bond prices fall when yields rise. Demand for tax-free income sought by wealthy individuals is set to grow. Demand for tax-sheltered investments has outpaced municipal bond supply. Investors are hard-pressed to find tax -free investments to reinvest coupon and redemption proceeds. Municipal bond funds have received cash inflows for 45 straight weeks aggregating to $65 billion, indicating strong demand for municipal bonds. Municipal bonds’ tax advantage makes them more resilient to market-led yield changes.

Second: Investors think inflation is coming down, and will average 2.5% over the next 10 years, based on the yields on regular and inflation indexed bonds. Current yields on long term bonds suggest that the bond market expects a rapid moderation of inflation. Federal Reserve Chair Powell also reaffirmed that the central bank expected inflation to peak in the middle of the year, suggesting a dramatic increase in interest rates may not be necessary. While the Federal Reserve is likely to move to control inflation, rate hikes are likely to be in moderation, to not trigger a recession. “The good news is that inflation has likely peaked”, Moody’s noted that the worst of U.S. inflation may be behind us. The gap between five and thirty-year yields fell below 50 basis points for the first time since March 2020, suggesting longer dated municipal bonds are likely to outperform shorter maturities that are more sensitive to Federal Funds rate hikes.

Third: Markets have revised down how high rates are likely to get. They see the federal funds rate, now near zero, reaching only 1.6% range in 2024, below the Fed’s expectations of a 2.1% rate in 2024. Fed Funds rate peaked at 2.4% in 2019 during the Fed’s last hiking cycle. Upcoming rate hikes are likely to be shallower than the Fed’s last rate cycle. Forward markets see only a mild rise in the bellwether 10-year Treasury yield, to 1.94% in one year and 2.06% in two years.

Fourth: A dimmer outlook for U.S. economic growth in the first quarter and 2022 comes amid fast-spreading Omicron variant, higher inflation and supply chain constraints. Economists downgraded first quarter growth by more a percentage point, to a 3% annualized rate, down from a 4.2% October forecast per a WSJ survey. Bond guru Jeffery Gundlach said he’s not ‘predicting a recession yet’ but sees those pressures building as he pointed out that the yield curve has seen a ‘pretty powerful flattening’ that is ‘approaching the point where it signals economic weakening’. The path of the U.S. economy is tied to the spread of the virus.

Fifth: Federal debt is more easily sustained with low rates. When economic growth is slower, federal leverage in relation to national economic output increases, an added impetus for moderating rate hikes. The Federal Reserve’s $8.7 trillion balance sheet is about 37% of GDP. Later this year, the Fed is likely to reduce its balance sheet by about $1.5 trillion to $2 trillion to around 25% of GDP, Moody’s estimates. Before the pandemic, the Federal Reserve’s balance sheet was about 20% of GDP. In 2018, the Federal Reserve hiked rates to 2.4%. At that time, Fed Chair Jerome Powell’s playbook was to reverse course when markets wobbled.

Sixth: For the last thirty years, yields on risk-free government bonds issued by advanced nations, U.S., Western Europe and Japan, have been declining broadly. “Their decline is due neither to the Global Financial Crisis of the late 2000s, nor to the current Covid-19 crisis, but to more persistent factors,” a former IMF economist explained. Slower population growth and longer life expectancy means that people save more and spend less, resulting in slower economic growth. The pandemic intensifies the trend. Last July, U.S. population growth plummeted to record low of 0.1% as both birthrate and immigration fell. The ‘Great Resignation’ caused the U.S. labor force to end last year 1.4% smaller than before COVID-19 struck. Demographic trends give hold to the notion of ‘secular stagnation’, which could keep interest rates low over the long term.

Seventh: Global investors’ search for higher interest rates in the United States is likely to clamp down U.S. Treasury yields. “While there may be scope in the US for 10-year rates to move higher, every time they do, bond investors overseas are likely attracted,” a Goldman Sachs investor summed. Active buyers of U.S. Treasuries, overseas investors are lured to higher U.S. bond yields; the onslaught of foreign demand boosts U.S. bond prices. After the Eurozone pledged not to hike rates despite inflation, the world’s second largest economy, China, cut two benchmark interest rates last week to lower lending rates, and the Chinese authorities are likely to step up monetary and fiscal support. Advanced nations’ central bank actions influence the Federal Reserve’s policy response.

Eighth: Higher prices bring revenue upside for some municipal bond sectors, a boost to credit quality. A host of government taxes such as sales taxes and toll collections grow when prices rise. Municipal bond financed projects correlated with economic activity carry higher pricing power, while rates for essential services such as utilities are fixed for adequate debt service coverage. During pandemic, government revenue outperformed and credit upgrades outpaced downgrades amid unprecedented federal support to states and local governments. Higher pricing power boosts revenue potential, and draws investors to take on more credit risk, a positive for high yield municipal bonds.

Ninth: Inflows to muni bonds outpace outflows over the long term. In 2021, outflows from municipal bond funds were recorded in five weeks. In 2020, the first year of the pandemic, outflows were recorded in only nine weeks, with inflows in all other weeks. There were no outflows in any week of 2019. 2018 saw outflows in 11 weeks of the year and 2017 saw outflows in two weeks per ICI data. Along with individuals, banks, insurance companies and foreigners are steady buyers of municipal bonds. Last week, high yield municipal bond funds saw their first outflow since October 2021. With close attention to market events, a municipal bond specialist procures tax-free bonds at attractive prices for long term investors.

Finally, when the Federal Reserve begins to hike rates, outflows from municipal bond funds cannot be ruled out. Mutual fund outflows cause institutional investors to sell tax-free bonds. Such a sell-off does not go unnoticed by astute investors.  Those who bought municipal bonds in March 2020 during the COVID-19-related sell-off when mutual funds were on a selling streak now tell of outsize gains. Robust demand for tax-free income and credit upside is a tailwind for high yield municipal bonds. The turn of the monetary cycle could be opportune in some ways.

Compare 30-Year taxable U.S. Treasury yield 2.14% to 30-Year tax-exempt muni bond yield “AAA” 1.70%; “AA” 1.98%; “A” 2.0%; “BBB” 2.71%. For investors in the 35% tax-bracket, a 2.7% tax-exempt yield is equivalent to a 4.15% taxable yield. Top rated tax-free bonds yield 79% of comparable taxable U.S. Treasuries.