Week of 7/18/2022

Inflation Hits New High…Inflation Expectations Fall… Recession Fears…Central Bankers Weigh Larger Rate Hikes…More Charter School Muni Bonds…Inflation Outpaces College Tuition…MTA’s Ridership Woes… Inflows to Muni Bond Funds…

Inflation Hits New High… June consumer price index, also known as headline inflation, surged 9.1% higher than a year ago, a new generational high. Core prices, which strip out volatile food and energy prices, are 5.9% higher than a year ago. At 3.1%, the gap between headline and core inflation is the widest since the Arab oil embargo of 1974. About a third of headline inflation surge came from higher energy prices. Energy prices have likely peaked, as gas prices have declined steadily since mid -June, and are down 25% from peak prices in March. Similarly, wheat futures contracts have fallen 60% from May’s peak prices. Lower commodity prices could subtract from headline inflation in July. Supply-chain related price increases have decreased this year. However, rents continue to accelerate pushing price levels higher. The outlook for prices to moderate remains precarious and could be upended swiftly as global and national events unfold.

Inflation Expectations Fall… Future inflation indicators have moved in tandem with oil prices. Longer-term, five to ten-year inflation expectation slipped to 2.8% from 3.1% prior per a University of Michigan preliminary survey for July inflation. “Breakeven” inflation rate, or the difference in yields on Treasury notes and inflation- protected Treasury securities, known as TIPS, has slid sharply. The five-year TIPS breakeven is now 2.66%, down from a 3.59% peak in March.

Recession Fears… A closely watched signal of recession risk, the yield curve, hit its most extreme level in two decades. Most sensitive to fed-funds rate hikes, two-year Treasury yield, 3.13%, is higher than 10-year Treasury yield, 2.91%. An inverted yield curve, when short term bonds yield more than longer-dated securities, has preceded almost every recession for the last 50 years. Higher than expected inflation readings brought the gap between shorter-term and longer-dated bonds to be the most inverted since 2000. Bond markets expect aggressive fed-funds rate hikes. Although the U.S. economy added significantly more jobs in June than expected, and retail sales grew 1% last month, a sense of uncertainty is reflected in recent economic surveys. After economic output shrunk 1.6% annualized in the first quarter of 2022, Wall Street has varying views on the timing of the next recession.

Central Bankers Weigh Larger Rate Hikes… Ahead of the Federal Reserve’s ‘quiet period’ that began Saturday Federal Reserve officials had lots to say about the July rate hike. Largely leaning towards a 75 basis point rate hike later this month, Fed officials opened the door to a 100 basis point rate hike at the Fed’s July meeting as the latest inflation reading is ‘concerning’. Fed Governor Christopher Waller reiterated his support for a 75 basis point rate move, but said he is open to a larger move if economic data warrant. Speaking of retail sales and housing, Waller said, “If that data comes in materially stronger than expected it would make me lean towards a larger hike at the July meeting to the extent it shows demand is not slowing down fast enough to get inflation down,” Cleveland Fed president wants to weigh incoming data. Atlanta Fed president said ‘everything is in play’ but is uneasy with moving rates too dramatically, as is Kansas City Fed president. St. Louis’ Fed president debates that a 75 basis point rate hike ‘has a lot of virtue to it’. Traders assign 35% odds of a 100 basis rate hike in July. Retired bond guru Bill Gross wants the Fed to hike rates from the current 1.75% to 3.5% “ASAP”. The futures market is pricing in a peak fed-funds target rate of 3.50-3.75% by December 2022, with the Fed possibly beginning to lower rates around middle of next year.

More Charter School Muni Bonds… This year charter schools have issued 15% more tax-free bonds compared to a year ago. While the broader municipal bond market is seeing lower bond volumes in the primary bond market, charter schools’ bond issuance is more than double the 10-year average. Charter schools are privately operated but receive federal, state and local funding. COVID-19 related federal aid has boosted the finances of charter schools, echoing the trend in K-12 public education sector. Virtual or hybrid learning programs, that charter schools pioneered pre-COVID, continue to see high demand post-COVID, credit positive for this public- private sector that tends to offer higher yields to bondholders. It remains to be seen if charter school operators will defer bond plans with rising interest rates.

Inflation Outpaces College Tuition… Colleges and universities are grappling with multi-fold effects of high inflation. Higher education wage bills, which account for nearly a third of college expenses, have risen. With high inflation, college tuition is up as much as 6% roughly, after remaining largely flat for the past two years. Enrollment is likely to suffer as tuition rises. Fear of a recession is a dampener on college demand. College endowments have suffered a steep decline as investment returns dwindled this year. This means, colleges will be hard-pressed for spending on capital plans or tuition grants. COVID-19 related federal has largely been used. Robust state funds have been a bright spot. Public universities derive almost a quarter of revenue from state funding. Lower-rated colleges, with structural imbalances, face steeper challenges.

MTA’s Ridership Woes… New York’s MTA’s budget gap may grow wider if ridership fails to pick up. “There is a possibility that our deficit may expand from what we’ve been working with in our previous plan because of updated projections,” MTA CEO warned of underperforming finances. Farebox collections are $288 million below budget this year through May, as weekday subway usage is still only 60% of pre-COVID-19 levels. In late 2020, McKinsey expected ridership to climb to about 86% of pre-pandemic levels in the fourth quarter of 2024. New Yorkers’ hybrid schedules have added to MTA’s woes. Meanwhile, MTA’s CEO is asking state lawmakers to fund public transportation like an essential service such as police, fire and sanitation.

Inflows to Muni Funds… Federal Reserve actions to combat high inflation favor municipal bonds. Investors added cash to municipal bond funds last week, favoring long term bond purchases. Since February, only three weeks have brought inflows to municipal bond funds. So far, investors have liquidated over $47 billion of municipal bond fund investments, leading up to record losses for municipal bond benchmarks. Cash flows to mutual funds are a gauge of demand for municipal bonds. Long term municipal bonds have gained 2% so far this month.

Compare 30-Year taxable U.S. Treasury yield 3.15% to 30-Year tax-exempt muni bond yield “AAA” 3.05%; “AA” 3.67%; “A” 4.04%; “BBB” 3.94%. 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 97% of comparable taxable U.S. Treasuries.