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Week of 1/31/2022
Munis Becoming A Buyers Market… Sooner, Faster Rate Hikes, Says Fed… Wall Street Boosts Rate Bets…Outflows From Municipal Funds… Municipal Bond Prices Getting Cheaper… Higher Tax-Free Yields… Economic Growth in 2022…
Munis Becoming A Buyers Market… Investors are waiting and watching as they brace for Fed rate hikes as early as March. Todays municipal bond market is a start contrast from last year when new municipal bonds were flying off the shelves. Most new municipal issues are finding it harder to price debt at initially offered yields and some bond issues have had to offer higher yield than anticipated. For several years including most of last year, municipal bond issuers have had the upper hand as most new tax-free bonds were oversubscribed and bond buyers struggled to find tax-free bonds to reinvest maturing bonds. Today, the opposite holds true. The primary market has seen much worse, however. Back in March 2020 several new bond issues struggled to find buyers. Then, uncertainty about COVID-19 led bond buyers to shun high grade New York City bonds, which soon bounced back to premium prices as clarity emerged. In January 2022, states and locals have issued $26 billion of new bonds, down 9% from a year ago. January municipal volume is still near January long term average issuance of $25 billion. A weak primary market is an outcome of uncertainty in capital markets facing impending rate hikes. A Citigroup analyst summed, “On the one hand, yes it’s cheaper,” he said. “On the other hand, could it get even cheaper? They’ll invest some now and wait for better buying opportunities.”
Sooner, Faster Rate Hikes, Says Fed… Fed Chair Jerome Powell signaled that the central bank is “willing to move sooner than we did the last time and also perhaps faster” as the “economy’s much stronger and inflation is much higher.” Powell shared, “But, beyond that, it’s really not appropriate for me to speculate exactly what that would be.” The Federal Reserve’s prior rate hiking cycle began in 2015, when U.S. Treasury Secretary Janet Yellen was at the helm, and ended in 2018 with a fed funds target rate of 2.5%. Powell clarified that changes in the federal funds rate target would be the primary means of implementing monetary policy and the Fed’s balance sheet reductions would be through adjusting reinvestments, not bond sales. Fed Chair Powell was clear that the central bank will wind up its bond purchases in Q1-22, and move to raise interest rates as often as needed to tame inflation, which is more persistent than expected. “While the drivers of higher inflation have been predominantly connected to the dislocations caused by the pandemic, price increases have now spread to a broader range of goods and services,” Powell added, “Like most forecasters, we continue to expect inflation to decline over the course of the year.”
Wall Street Boosts Rate Bets… Goldman Sachs sees five rate hikes in March, May, July, September and December and expects officials to announce the start of a balance sheet reduction in June. Now, Bank of America predicts seven rate hikes in 2022 and BNP Paribas forecasts six, while JPMorgan Chase and Deutsche Bank see five. Nomura Holdings reckons the central bank will deliver a 50 basis points increase in March. TD Bank forecasts there will be four rate hikes this year. Minneapolis Fed President Neel Kashkari told National Public Radio on Friday that “we just don’t know” if the three rate hikes signaled by the Fed in its last quarterly forecasts, released in December, would be enough to get inflation in check. “It is going to depend on supply chains. What happens to workers,” he said. Trading in federal funds futures suggests a 66% probability of five rate hikes in 2022. The federal funds rate could be 0.375% in March 2022 and 1.27% at the end of 2022.
Outflows From Municipal Funds… In January 2022, municipal bond funds saw outflows of $1 billion, the first sell-off since March 2020 when COVID-19 first made headlines. In March 2020, municipal funds saw mass redemptions or outflows of $38 billion over two weeks, which came after 60 consecutive weeks of inflows totaling $116 billion. Barclays said that historically, municipal fund outflows have lasted about two months. Early days of outflows from municipal bond funds suggest attractive opportunities could be at hand in the near term.
Municipal Bond Prices Getting Cheaper… Municipal bond prices are sharply down, falling 2.3% in January, the worst monthly performance since March 2020. Treasury bonds have lost 1.9% in January, and municipal bonds are part of the broader sell-off led by rate uncertainty. Top rated benchmark tax-free 30-year bonds yield about 95% of comparable U.S. Treasury yields. The ratio of relative value, is the highest since March 2020. A higher ratio suggests that municipal bonds are underpriced relative to U.S. Treasury bonds. Amid dire predictions of steep government revenue losses that never came true, the Municipal Treasury yield ratio climbed to 252% on March 23, 2020 and stayed unusually high for about three months before steadily dropping to a low of 68% in February 2021 as municipal bonds outperformed. The Municipal Treasury ratio has averaged about 68% for the past year, reflecting high prices for municipal bonds that came with strong cash inflows to muni funds. Muni bond investors must be patient, and most investors should not rush to buy bonds as municipal bonds could go even lower in price.
Higher Tax-Free Yields… Yields on 10-year benchmark municipal bonds have climbed 24 basis points this week to 1.53%, in the biggest jump since February 2021. During the global COVID-19 capital market sell-off in March 2020, 10-year top rated municipal yields spiked to 2.88% tax free, falling sharply thereafter to a record low of 0.54% in August 2020. In 2021, municipal yields increased hovering around 1% for 10-year top rated benchmarks. Municipal bond yields at sixty-year lows in recent years adversely impacted HNWs tax-free income as many tax-free bonds were refinanced with lower yielding bonds. Wealthy investors had to contend with steep municipal bond prices and little yield compensation for credit risk. Yields on tax free state and local government bonds move with comparable taxable U.S. Treasury yields. In 2021, U.S, Treasury yields rose more than 50 basis points and hovered in the 1.45% to 1.7% range at year-end. Some analysts predict that the 10-year U.S. Treasury yields could end the year between 2% and 2.25% or higher, a 50-75 basis points rise from recent levels. During a rising rate environment, municipal yields are likely to trend higher. The fundamentals of the $4 trillion muni bond market are even stronger post-COVID-19. Higher yield trend could present an opportunity for investors to deploy cash in the $4 trillion municipal bond market, second in safety to none other than U.S. Treasuries, for higher tax-free income.
Economic Growth in 2022… The forecasting firm IHS Markit projects that output will grow at a 2% annual rate in January through March. That would mark the weakest quarter of growth since the recovery began in mid-2020. Last week, the company gave an early peek at economic growth when it reported that its index of U.S. services and manufacturing activity, covering most of economic activity, slowed sharply. The U.S. economy grew at 6.9% annual clip in the fourth quarter, the strongest rate in four decades. “The path of the economy continues to depend on the course of the virus,” the Fed wrote that “Risks to the economic outlook remain, including from new variants of the virus.” IMF cut its forecast for US economic growth this year to 4%, down from 5.2% in its October outlook. In the U.S., fewer hopes for the Build Back Better fiscal package, an earlier withdrawal of extraordinary monetary accommodation, and continued supply disruptions will weigh on the economy. The IMF noted, “Supply-demand imbalances are assumed to decline over 2022 based on industry expectations of improved supply, as demand gradually rebalances from goods to services and extraordinary policy support is withdrawn. Moreover, energy and food prices are expected to grow at more moderate rates in 2022 according to futures markets. Assuming inflation expectations remain anchored, inflation is therefore expected to subside in 2023.
Compare 30-Year taxable U.S. Treasury yield 2.1% to 30-Year tax-exempt muni bond yield “AAA” 1.91%; “AA” 2.2%; “A” 2.68%; “BBB” 3.01%. For investors in the 35% tax-bracket, a 3% tax-exempt yield is equivalent to a 4.6% taxable yield. Top rated tax-free bonds yield 91% of comparable taxable U.S. Treasuries.