Munis weaker but outperform UST selloff after GDP report

Bonds

Munis yields rose Thursday, following and outperforming a U.S. Treasury sell-off on the heels of strong-than-expected economic data. Equities ended down.

Thursday’s “economic data offers the latest evidence that the U.S. economy is weathering the fastest rate hikes in a generation without much damage to the major gear-works of the economy,” said Wells Fargo Securities senior economist Tim Quinlan and economist Shannon Seery.

The path to “avoiding recession looks clearer today than it did even a few weeks ago,” they said.

Treasuries whipsawed on the data with yields rising by as much as 14 basis points. Triple-A muni yields were cut one to 12 basis points, depending on the scale, with some of the largest cuts on Refinitiv MMD’s short end.

The two-year muni-to-Treasury ratio Thursday was at 59%, the three-year at 59%, the five-year at 60%, the 10-year at 63% and the 30-year at 87%, according to Refinitiv MMD’s 3 p.m. read. ICE Data Services had the two-year at 60%, the three-year at 62%, the five-year at 61%, the 10-year at 66% and the 30-year at 90% at 4 p.m.

Municipal bond mutual fund saw inflows for the second week in a row with Refinitiv Lipper reporting investors added $552.219 million to funds for the week ending Wednesday following $1.040 billion of inflows the previous week.

Investors are currently “trying to manage the Fed’s rate hike [Wednesday], and also trying to obtain a little more of an additional feel as far as what this means for monetary policy for the second half of this year,” said Matthew Gastall, executive director and head of Wealth Management Municipal Research and Strategy at Morgan Stanley.

Muni seasonals are, as expected, very constructive right now, he said.

Redemptions in June, July and August will likely be greater than in the first five months of the year.
He said demand should remain healthy until Labor Day, but supply, given the seasonals and where rates are, may remain manageable.

The supply-demand “imbalance that we’ve been managing over the course of 2023 has continued and, as anticipated, may be exacerbated this summer,” Gastall said.

He noted technicals appear to be having more of an impact than macroeconomic developments.

This can be seen in muni-UST ratios.

The 10-year muni-UST ratio is still below 65% Thursday, according to MMD, whereas the long-term historical average is closer to 83%.

“That’s really consistent with the fact that the technicals and seasonals are very constructive in munis right now,” he said.

Relative yields may stay “stubbornly” low for some time, said Cooper Howard, a fixed income strategist at Charles Schwab.

Yields relative to Treasuries are “well below their longer-term averages and have been so for most of the year,” he said.

Due to the shape of the yield curve, he said muni investors have preferred short-term bonds, “which has resulted in yields being suppressed compared to Treasuries.”

Until the slope of the yield curve becomes positive again, Howard expects short-term valuations to remain low.

The prospects for munis bonds entering Q3 are “encouraging,” said Kara South, municipal bond portfolio manager at GW&K Investment Management.

More attractive tax-equivalent yields are “stoking demand just as the tailwinds from the summer technical environment are about to strengthen,” she noted.

Coupon and maturity redemptions are expected to outpace issuance by nearly $30 billion over the next two months, “creating a net negative supply dynamic capable of powering summer returns,” she said.

Fundamentals remain solid, South said, noting that most states started this fiscal year “expecting a normalization of tax revenues from the sky-high levels of the pandemic era.”

Forward-looking budgets have “anticipated a slowdown in growth, weaker capital gains and the end to the federal relief windfall,” South said.

If things are worse than expected, she said “record high rainy-day funds, built on years of surpluses, stand ready to bridge any gaps.”

Valuation is an area of caution, she said.

Due to the outperformance in June, ratios tightened, but she said “if there were ever a time to pay a premium for municipal bonds relative to the rest of the fixed income space, it’s hard to imagine a scenario that better aligns fundamentals with technicals, especially entering a period that may shower favor on high-quality asset classes with a reputation for stability.”

Secondary trading
Oregon 5s of 2024 at 3.16%. NYC 5s of 2024 at 3.07%-3.05% versus 3.10% on 7/6. California 5s of 2025 at 2.91%. Wisconsin 5s of 2025 at 3.00%-2.98%.

Maryland 5s of 2028 at 2.58%-2.59%. Washington 5s of 2028 at 2.67%. North Carolina 5s of 2029 at 2.64% versus 2.60% on 7/20.

Indiana Finance Authority 5s of 2033 at 2.78% versus 2.78% on 7/21 and 2.91% original on 7/19. Virginia Building College Authority 5s of 2034 at 2.68%-2.65% versus 2.71%-2.70% on 7/5. California 5s of 2034 at 2.59%-2.61% versus 2.59% Tuesday.

Raleigh Combined Enterprise System, North Carolina, 5s of 2048 at 3.58%-3.55% versus 3.64% on 7/13. Massachusetts 5s of 2053 at 3.85%-3.84% versus 3.81%-3.80% Wednesday and 3.79%-3.80% Tuesday. NYC TFA 5s of 2053 at 3.91%-3.93% versus 3.90% Tuesday and 3.90%-3.89% Monday.

AAA scales
Refinitiv MMD’s scale was cut two to 12 basis points: The one-year was at 3.14% (+12) and 2.97% (+12) in two years. The five-year was at 2.62% (+10), the 10-year at 2.52% (+2) and the 30-year at 3.51% (+2) at 3 p.m.

The ICE AAA yield curve was cut five to six basis points: 3.07% (+5) in 2024 and 2.94% (+5) in 2025. The five-year was at 2.55% (+5), the 10-year was at 2.52% (+5) and the 30-year was at 3.52% (+5) at 4 p.m.

The S&P Global Market Intelligence (formerly IHS Markit) municipal curve was cut one to three basis points: 3.05% (+3) in 2024 and 2.88% (+3) in 2025. The five-year was at 2.53% (+1), the 10-year was at 2.52% (+1) and the 30-year yield was at 3.50% (+1), according to a 3 p.m. read.

Bloomberg BVAL was cut up two to three basis points: 2.97% (+3) in 2024 and 2.86% (+3) in 2025. The five-year at 2.53% (+3), the 10-year at 2.48% (+3) and the 30-year at 3.49% (+3) at 4 p.m.

Treasuries sold off.

The two-year UST was yielding 4.923% (+9), the three-year was at 4.583% (+11), the five-year at 4.240% (+14), the 10-year at 4.000% (+14), the 20-year at 4.250% (+12) and the 30-year Treasury was yielding 4.042% (+11) near the close.

Mutual fund details
Refinitiv Lipper reported $552.219 million of inflows into municipal bond mutual funds for the week ending Wednesday following $1.040 billion of inflows the week prior.

Exchange-traded muni funds reported inflows of $249.771 million after inflows of $1.184 billion in the previous week. Ex-ETFs muni funds saw inflows of $302.448 million after outflows of $144.395 million in the prior week.

Long-term muni bond funds had inflows of $591.430 million in the latest week after inflows of $1.030 billion in the previous week. Intermediate-term funds had $185.821 million of inflows after inflows of $121.952 million in the prior week.

National funds had inflows of $611.918 million after inflows of $1.047 billion the previous week while high-yield muni funds reported inflows of $223.444 million after inflows of $408.477 million the week prior.

FOMC redux
The Federal Open Market Committee meeting opted to hike rates 25 basis points at the conclusion of Wednesday’s meeting. This was in line with market expectations, but there are still several unanswered questions and challenges ahead, experts said.

The critical question is “how the Fed chooses to respond to still-elevated but cooling inflation amidst signs of resilient growth and uncertainty over the precise length and impact of lags associated with monetary policy,” said Mickey Levy, chief economist for Americas and Asia at Berenberg Capital Markets, and a member of the Shadow Open Market Committee

He said it was notable that Fed Chair Jerome Powell, “despite acknowledging progress on disinflation, was quick to emphasize that the Fed’s job is not done.”

That the Fed “opted to keep the policy statement virtually unchanged is telling,” he said.

“What we see as particularly tricky for the Fed from here, the easy comparisons for headline inflation have now rolled off and it is likely that headline prints will come in at 3% or higher for the rest of the year,” said Tony Welch, Chief Investment Officer at SignatureFD.

“Making headline inflation even more challenging, many commodities have begun to show strength, inclusive of grains and energy,” he said. “There are also numerous labor disputes that have yet to be resolved.”

Welch said he believes “core inflation will continue its disinflationary trend throughout the rest of the year but the disinflation in headline inflation is now largely behind us for the balance of the year.”

“And where there were downside inflation risks for the year’s first half, the balance of risk is now to the upside for inflation,” he added.

Emin Hajiyev, senior economist at Insight Investment, expects “the Fed will be keen to keep financial conditions tight, through its market communications, to avoid another upswing in inflation pressures.”

The market may “no longer be underestimating the Fed’s willingness to keep rates at restrictive levels,” he said.

Earlier in the year, Hajiyev said “Fed Funds futures markets were projecting rate cuts before the end of 2023, despite Fed guidance only moving higher over time.”

However, he noted “markets have changed their tune and are now more in sync with the Fed’s dot plot.”

“This is encouraging for the Fed, implying its policy is having the desired impact on financial conditions, and we expect the Fed to continue to lean hawkish to help guide monetary policy,” Hajiyev said.

Economists think the Fed is approaching the end of its tightening cycle but said they wouldn’t be surprised if there are still more rate hikes to come.

“Some signs of softer core inflation and labor market conditions by September [would be] sufficient to dissuade the Fed from hiking then,” said David Page, head of Macro Research at AXA Investment Managers.

He said he believes “the Fed has reached its peak rate for now, but in truth the risks of a further hike are likely to persist over the summer.”

“Another hike over the coming months is possible but we would also not rule out Wednesday’s meeting marking the end of the hiking cycle,” Hajiyev said.

Welch said “the market is only pricing in about a 40% chance of another rate hike,” but he sees an additional hike as a higher probability.

Depending on inflation levels and price changes, Phill Nelson, head of asset allocation at investment consulting firm NEPC could see one or two more hikes by the end of this year.

The shift lower in the rate curve “indicates that the market thinks we’re near the end of the rate hike cycle,” said Ali Hassan, portfolio manager at Thornburg Investment Management, though he believes “September is still in play for a hike.”

“Nothing has changed in terms of how the Fed balances the set of risks, and they want to see data confirmation,” he said.

Hasson fears “the Fed will hike us into a recession, and the Fed appears comfortable with this risk.”

GPD rises 2.4% in Q2
The U.S. economy grew faster than anticipated last quarter, with the gross domestic product rising 2.4% in Q2. This is up from the 2% growth seen in Q1.

“The is a strong report, confirming that this economy continues to largely shrug off the Fed’s aggressive rate increases and tightening credit conditions,” said Olu Sonola, Fitch Ratings head of U.S. economics.

The resilience of “consumer spending continues to underpin broad-based economic growth and business investment was stronger than expected,” he said. 

“Residential investment declined for the ninth consecutive quarter, despite a rebound in home prices during the quarter,” Sonola added.

Essentially, Wells Fargo Securities economists said “the core parts of the economy remain in solid shape.”

While economists are still divided on the possibility of recession, they said Thursday’s report “raises the odds of a soft landing.”

That said, Wells Fargo Securities economists noted “it likely also keeps the heat somewhat turned up on the Fed.”

“To the extent that the core parts of the economy remain hot, the Fed may find it more challenging to rein in still-elevated inflation,” they said.

The Fed will “leave the door open to further rate hikes, but the legacy of past rate hikes and tighter lending conditions will restrain activity and dampen price pressures, negating the need for further action,” said ING chief international economist James Knightley.

“The bottom line is that the U.S. economy is still growing above trend and the Fed will be wondering if they need to do more to slow this economy,” Sonola added.

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