Week of 4/25/2022

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‘Front-Loaded’, Faster Rate Hikes, Powell… Record High Inflation Expectations… Bargain Hunters Look For Amid Uncertainty… Recession or Lower Growth?… Illinois Earns Rating Upgrade…

‘Front-Loaded’, Faster Rate Hikes, Powell… Ready to embark on a forceful tightening of financial conditions, the Federal Reserve signaled a departure from gradual rate hikes it advocated earlier. “It is appropriate in my view to move a little more quickly,” Fed Chair Powell’s comments last week boosted odds for steeper rate hikes in 2022. “There’s something in the idea of front-end loading” of rate hikes if appropriate,” Powell signaled last week that “50 basis points will be on the table for the May meeting.” More central bankers appear convinced with the idea of a 50 basis point rate hike in in May. St. Louis Federal Reserve President James Bullard did not rule out 75 basis point rate hikes. Nomura Research economists expect 75 basis point rate hikes at several Fed meetings this year, which could raise the fed-funds rate to 3%-3.25% by year-end. The Fed has not hiked rates by 75 basis points since 1994. The fed-funds rate is expected to be 0.75%-1% in early May. Trading in futures suggests near even odds between 2.75%-3% and 3%-3.25% fed- funds rate by year-end.

Record High Inflation Expectations… A closely watched gauge of inflation expectations over the next decade has shot up to a record high. The U.S. 10-year break-even rate, which measures the difference in traditional U.S. government bond yields and those on inflation- adjusted Treasuries, climbed to 3.08% last week. Very high inflation expectations reflect current high inflation, 8.5% in March, that comes from the surge in food and oil prices. But the Federal Reserve’s preferred inflation gauge, which strips out current inflation levels and looks at the second half of the next ten years, also hit 2.84%, the highest since 2014. Inflation could be 5% or 6% this year and moderate down to 4% in 2023, compared to 7% in 2021, per two-thirds of Big Money survey respondents. “Maybe we will see 10% inflation,” bond expert Jeffrey Gundlach said inflation could fall in the months ahead, but not to 4% this year, as some are predicting. A lot depends on energy prices, with oil at $100/barrel currently. The 10-year Treasury yield, a benchmark for borrowing costs worldwide, rose to a high of 2.95%, while the 2-year Treasury yield, which is closely tied to fed funds rate, rose to 2.73%. High inflation has triggered a sell-off in the tax-free bond market. A stark departure from 2021’s high municipal bond valuations, losses to municipal bond benchmarks are near 9% this year.

Bargain Hunters Look For Bonds Amid Uncertainty… Tax-free bonds yield 105% of comparable taxable Treasury yields, compared to an average of 83% over the last year. Amid caution that yields could go higher still, current higher yields are tempting to some large and long term bond investors. “We view the current level of 10-year [US yields] as a compelling location [to buy the debt],” said rates strategists at Bank of America last week. “Inflation concern has reached a level of mania or panic,” the bank cited “extreme” inflows into inflation-protected bonds as well as a spike in internet searches for “inflation”. “Our forecasts point to inflation peaking this quarter and falling steadily into 2023. We believe this will reduce the panic level around inflation and allow rates to decline,” Bank of America added. Columbia Threadneedle’s strategist told FT that although yields might move higher, “Gosh, they’re high enough now to buy.” A bond fund portfolio manager at Nomura Asset Management said he had been “adding little bits of exposure” to long-dated bonds as yields rose. “I think it’s too early to call the top in yields right now,” Nomura bond fund manager added, “but central bankers know that raising interest rates materially from these levels is going to push economies into recession. And I’m convinced inflation is going to roll over later this year, so long-end yields are starting to look attractive.” A bond fund manager at Abrdn summed, “If I could close my eyes and come back in six months I think I would be comfortably in the money by buying here,” adding “But the potential journey to get there is so uncertain that it’s hard to get the timing right. All it takes is a big upside surprise to inflation or some loose-lipped Fed speak and yields shoot up again.”

Recession or Lower Growth?…“The trajectory we’re on is a photographic negative of Goldilocks…the landing strip to achieve a soft landing feels very narrow—and the history book of Fed tightening cycles doesn’t have a happy ending” Goldman Sachs economists put the odds of a recession at about 35% over the next two years, with lower 15% odds for a recession in the next 12 months. “There isn’t a sign that the economy is going to tip into recession simply because we’re removing accommodation. It’s demonstrated they can self-sustain,” San Francisco Fed Reserve President Mary Daly countered on the risk of recession. The U.S. economy is on track to grow 3.7 percent in 2022, 0.3 percentage point lower than January projections, and 2.3 percent in 2023, down from 5.7% last year the IMF contends. Wall Street argues that the U.S. economy to grow between 1.5% to 3.3% in the fourth quarter of 2022 relative to a year ago. “Outlooks for future growth were clouded by the uncertainty created by recent geopolitical developments and rising prices,” Federal Reserve’s Beige Book survey stated last week. Growth forecasts pale compared to prior three quarters’ solid growth +12.2%, +4.9%, and +5.6% that largely came from $3.6 trillion COVID-19 federal relief spending. Pandemic related programs ended last year, but Americans built a financial cushion of $2.4 trillion of savings during the pandemic, a prop for future spending. “Fiscal policy is going to be less supportive of growth this year,” Fed Chair Powell said that waning fiscal support is one of “multiple forces which should be working over the course of the year for inflation to come down.” The effect of higher interest rates often lags economic growth by six to nine months, so more weakness is expected. 11 out of 14 tightening cycles in the U.S. since World War II were followed by a recession within two years. The Fed will likely continue to hike rates amid slowing economic growth and recession warnings.

Illinois Earns Rating Upgrade… Moody’s raised the rating of the State of Illinois to ‘Baa1’ from ‘Baa2’, the third upgrade for the lowest rated U.S. state in a year. Illinois’s first rating upgrade in 24 years came from S&P in July 2021. The latest upgrade “reflects the state’s solid tax revenue growth over the past year, which expanded its capacity to rebuild financial reserves and increase payments towards unfunded liabilities,” Moody’s added “The state is on track to close the current fiscal 2022 with its strongest fund balance in over a decade.” Unfunded pensions are the state’s single-largest liability. Lean financial reserves, and heavy long-term liability and fixed cost burdens make Illinois more vulnerable than other states to economic cycles. “There’s more work to be done, but step by step, rung by rung, we are steadily climbing the ladder out of a hole that was dug over decades,” Governor Pritzker added “Fiscal responsibility is paying off.”

Compare 30-Year taxable U.S. Treasury yield 2.89% to 30-Year tax-exempt muni bond yield “AAA” 3.03%; “AA” 3.63%; “A” 3.87%; “BBB” 4.20%. For investors in the 35% tax-bracket, a 4.2% tax-exempt yield is equivalent to a 6.4% taxable yield. Top rated tax-free bonds yield 105% of comparable taxable U.S. Treasuries.