Spring Is in the Air – We’ll see if the Fed Agrees

Spring is an optimistic time of year, with the smell of grass and fresh flowers, longer days and bright sunshine. And it is so predictable – it happens every year!

If only the economic cycle were as predictable! Recessions happen infrequently and the last one ended in June of 2009.

One of the classic tools for predicting recessions is the NY Fed’s “Probability of U.S. Recession Predicted by Treasury Spread – Twelve Months Ahead.” This model uses the difference between 10-year and 3-month Treasury rates to calculate the probability of a recession in the United States twelve months ahead. As you can imagine, the Fed has been tracking and analyzing this data for decades and it does a pretty good job.

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As the data indicates, it is hard to see a recession in 2019 with the U.S. economy still so strong. But as the chart also shows, the risk of a recession can rise or fall suddenly for any number of reasons. What we take way from this data is treasury spreads indicate the economic cycle is at least in late fall: leaves are turning red and gold and there is chill in the evening air.

We will get an update from the Fed this week when the Federal Open Market Committee meets to set monetary policy. The post-meeting statement and press conference will provide insights into the FOMC’s thinking on both the economy and interest rates. We don’t expect any changes to the Fed Funds Rate, but like so many previous meetings, all eyes will be on the dot plot, which highlights committee members expectations for future rate moves.

Markets also do a good job of anticipating the changing of the season and will move ahead of an actual recession. We note investment grade credit spreads appear to have reached their cyclical tights in February 2018, and the last S&P 500 top was in September 2018.

In the coming weeks we will start getting outside more often to enjoy the sunshine, and we will also ensure portfolios are getting ready for cooler weather.

Source: NY Federal Reserve

Munis Continue Their Hot Streak – Creates Opportunities for Crossover Investors

The municipal market has started off 2019 in a strong way, with tax-exempt municipal bonds now trading at some of the richest valuations versus taxable bonds on record. Driven by robust demand (as measured by mutual fund inflows) and light supply (as measured by new issuance), the positive technical environment has been one of the main drivers of the rally.

To measure the relative value of tax-free munis versus taxable bonds, we often analyze the ratio of municipal yields versus Treasury yields. As shown in the chart below, this ratio has dropped over the past 12 months, particularly for short to intermediate maturities such as five and ten years.

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While there are no immediate signs of this trend reversing, these absolute yield levels have created an opportunity for crossover investors to sell munis, purchase taxable bonds, and increase the after-tax yield generation on their portfolios. For example, the after-tax yield for investors in a mid-level tax bracket is 0.19% higher on a 1-year US Treasury Note as compared to a 1-year AAA municipal bond.

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The after-tax yield advantage is even more dramatic for corporate and taxable municipal bonds, which carry additional yield because of a credit spread premium.

These relationships are particularly relevant for our Blend Strategy, which has the leeway to invest in a mix of taxable and tax-free bonds. After increasing our allocation to tax-free municipals in the winter of 2017 during a muni market sell-off, we’ve been slowly capturing municipal outperformance by selling munis and buying taxable bonds. We executed on another leg of this trade last week as the after-tax yield opportunity has become too good to ignore.

Source: Barclays, Bloomberg

“Patience” May Be Replaced By “Flexible” As the Fed Debates Inflation

Fed Chair Powell gave his semi-annual testimony to Congress last week to present an assessment of the current state of the U.S. economy. To summarize his views, economic growth remains steady, the labor market remains strong and inflation is well contained. However, downside risks are visible, particularly those from what is becoming a pronounced slowdown in overseas economies, which has the potential to dent growth here at home. As such, the FOMC is committed to patience before raising the Fed Funds Rate in 2019 after hiking rates four times last year.

The word “patience” has become the most popular way to describe the Fed this year, but we would argue “flexible” may take the top spot moving forward. This is because Powell, along with a host of other committee members in recent weeks, has begun to highlight the months-long review of its policy framework, which appears to be centered around the current inflation target of 2%. The formal inflation target of 2% was introduced in 2012, but inflation has generally remained below that since the financial crisis.

Inflation ex. Food and Energy (Core)

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With inflation having lagged below target, the Fed is debating whether to become more flexible in how it assesses setting the Fed Funds Rate. Currently, the Fed targets 2% inflation each year, without regard to what has occurred in the past. One alternative would be to react to what happened previously by taking historical inflation into account when setting policy rates. For example, if inflation was below 2% last year, the FOMC could let inflation rise above 2% this year without raising rates. Another potential approach would be to target an average level of inflation at 2% over the course of the business cycle. As Powell put it, “think of ways of making that inflation 2% target highly credible, so that inflation averages around 2%, rather than only averaging 2% in good times and then averaging way less than that in bad times.”

In either approach, the flexibility around the current level of inflation and policy rates will be key. In a flexible environment, the Fed would avoid raising the Fed Funds Rate if inflation breaks above 2%. Longer-term bond yields would likely rise in this situation as higher inflation eats into the real value of future interest payments. Despite all this talk, the bond market has remained quite steady this year, which means investors aren’t concerned with inflation moving higher or this new approach being implemented, or a combination of the two.

Source: Bloomberg, NatWest Markets, WSJ

Housing Finance Authorities: A Pocket of Value in an Increasingly Crowded Municipal Market

As part of our municipal credit research process, we regularly take a deep dive into the various sectors of the municipal market. In February, we reviewed and confirmed that Housing Finance Authorities (HFAs) remain one of our favorites. At just over a 1% weighting within the benchmark, HFA’s represent a small portion of the overall muni market, but with strong credit profiles and attractive yields, they represent big value.

Housing Finance Agencies are agencies established by state or local law to provide financing for affordable housing. They play an important role in the housing market as HFAs are used to support single‐family mortgage loans at below market rates or finance affordable multifamily rental projects. HFAs sell tax‐exempt and taxable housing bonds and use the proceeds to support families with incomes below thresholds established by their individual governing body. Both single and multi-family bond issuances are structured as being self-supporting, and debt service is repaid from the loans they finance.

Most issuers are rated in the 'AA' category and housing is one of the highest‐rated sectors in the municipal market. The high ratings are the result of having issues supported indirectly by the U.S. government through loan insurance. Single family loans benefit from the muni/treasury spread, ensuring a competitive advantage over conventional loans, low unemployment rates, and favorable loan-to-value ratios. Multi-family projects are important and typically exhibit low vacancy rates, as there is limited affordable rental supply among the low-to-median income population. The northeast and west coast, where housing costs are particularly high, have strong demand for such affordable rental housing units.

The very high portion of insured loans, oversight, and healthy loan‐to-value ratios should support the ratings even during a downturn. Stresses occur during rising unemployment and increasing loan default rates. HFA’s have strong loan underwriting to minimize risk at origination, and servicing practices to help cure troubled loans. Loan repayment to service the debt should be manageable during a downturn as most loans are MBS, government enhanced, have primary mortgage insurance, or are uninsured with a loan to value below 80%.

All of these factors contribute to the attractiveness of the sector, and are reasons we carry an allocation to HFA’s across our municipal strategies.

Source: SNW Asset Management Research

Snowstorms and Cold Economic Data

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Two stories gripped Seattle last week. The first was the snowiest February in 100 years, and the second was some equally cold economic data. Though the events are certainly not related, as correlation does not imply causation, there is a common moral to these stories.

First, the snow. Seattle does many things well including technology, aerospace, ecological awareness and the perhaps the best public ferry system in the world. But it appears Seattle is less than efficient in plowing its roads when it snows. Everything was snarled for days and grocery shelves were stripped bare. Luckily the snow melted fast and all is now back to normal.

The second story is the cold economic data. Last Thursday the U.S. Census Bureau finally released its December retail sales data, which showed the sharpest drop in a decade. Headline retail sales dropped 1.2% month-over-month, far worse than the 0.2% increase economists anticipated. Retail numbers were weak across the board. Even the “control” category of sales, which strips out items including cars, gas, building materials and food services, reported the poorest reading since 2001. Also on Thursday, Germany’s 4th quarter GDP came out at 0.0%, just above the negative reading in the 3rd quarter. The economic engine of Europe is at stall speed. Finally, on Friday January’s industrial production numbers came in far weaker than expectations. All in all, it was a chilly end to the economic week, leaving the markets to worry about economic prospects in 2019.

So, what is the common thread between these stories? Snow melts fast in Seattle’s temperate climate, and weak economic news should soon dissipate as the U.S. is still growing above trend, unemployment is at generational lows and the Fed is patient. As for your portfolios, we know despite the vagaries of weekly economic data that the overall trend for economic growth is weakening, so we will maintain our conservative risk positioning.

Sources: Bloomberg, The Financial Times, The U.S. Census Bureau