The Fed Un-Hike

On March 15th, the Federal Reserve pulled off the seemingly impossible. They raised the target for the fed funds rate by 25 bps to 75 bps - 100 bps and made everyone think they were almost dovish! We are still all in amazement two weeks later. 

So how did they convince the markets that raising rates is really an un-hike? Partially with cleverly managing expectations and part with fundamentals. As far as expectations, the Fed was clear to forecast its expectation for three hikes this year when some were anticipating four hikes. The FOMC members also scaled back their longer-term target for unemployment to 4.7% from 4.8%, which allows them to be accommodating for longer, said they are looking for a sustained return to 2% inflation, and to cap off the dovishness there was even an unexpected dissenter, Minneapolis Fed President Kashkari. As far as fundamentals, the fed fund rate is still way too accommodating by most all measures, and perhaps the markets understand economic fundamentals are really good enough for some normalization of short-term rates.

The Fed may have mastered the short-end of the curve yet longer term rates are still mostly beyond their control. Since the Fed announcement on the 15th longer term rates have actually fell. So obviously, there are some cross currents in the rates markets.  The one current pushing longer rates higher would be improving GDP growth as the OECD recently projected and reinforced with last Friday’s encouraging US durable goods economic print and a strong European purchasing managers index number.

However, it appears there are stronger currents keeping longer rates in check which include cyclically high debt levels across the US, lower productivity, the drag from demographic shifts, a strong dollar, reducing global trade and still very low rates in Europe and Japan. Finally, the markets do seem to be factoring lower expectations for growth as the administration’s pro-growth legislative agenda meets the realities of governing, as we saw last week.

The opportunity for more income in the front end of the curve and some price stability in the longer end is not a bad combination. Let the un-hikes continue!

Sources: Federal Reserve, Bloomberg, BCA

Hope Deferred

The hope for economic growth much beyond 2.0% looks to be deferred, as legislation appears to be bogging down and the Fed is reducing monetary support, clearly taking the path to interest rate normalization. 

Hope is fading for robust economic growth fueled by tax reform, infrastructure spending and regulatory reform. Writing and signing major legislation takes far more time and effort than executive orders. Before arriving at the potentially stimulative tax reform and infrastructure spending we need to get through the repeal and replacement of the Affordable Care Act, the budget process and immigration reform. All these issues are politically contentious, and compromise will likely prove time consuming. Once we reach tax reform, the Border Adjustment provision looks to be a major stumbling block for many important constituents. We do take some comfort in the possibility of regulatory relief due to less enforcement, but meaningful regulatory change through legislation is looking like a long shot. 

No longer a long shot are continued increases in the fed funds rate. Last week the Fed made it clear we are on the road to a normalization of interest rates. It’s happening. The Fed’s dot pattern shows an expectation of the fed funds reaching 3.0% in 2019. Nobody is surprised. Unemployment is lower, job creation is good and inflation is picking up. However, while we are currently pleased the economy is strong enough to warrant normalization, the end game is that the Fed will eventually want to cool economic growth to keep inflation in line. 

FOMC participants’ assessments of appropriate monetary policy

Despite the disappointment over lower expectations for economic growth – the deferred hopes we mentioned above – this environment is really quite good for bond portfolios. A measured normalization of interest rates will gradually increase the income in fixed income portfolios with relatively low price volatility. We think it’s important to note that interest rates from 2 years to 30 years declined last week, even with the Fed raising the Federal Funds rate. Should normalization continue with long-term rates remaining range bound, this change will be appreciated after the last seven years of the Fed’s zero interest rate policy (ZIRP), delivering on hopes for higher income! 

Source: The Federal Reserve, Bloomberg, The Financial Times, Bank of America Merrill Lynch

Stormy Weather: Preparing Muni Portfolios for the 2017 Hurricane Season

At our Monthly Muni Strategy Meeting last week, the investment team analyzed the potential risk of hurricanes on Muni bond sectors and Muni credits. One might ask, why talk about hurricanes during a week when winter storms dropped snow in the South and caused blizzard conditions in parts of the Northeast? We believe it is important to understand the potential impact of natural disasters on municipal credits, and as hurricane season begins in about 70 days, it is worth understanding the risks to portfolios well before a storm is at your doorstep.

While wind and storm surges from hurricanes have the potential to cause billions of dollars of damage, most municipal credits have been able to maintain strong credit quality even after a storm has passed. One reason that the financial impact from a storm may be mitigated is that municipal governments benefit from the assistance property and casualty insurers provide for property owners who make up the tax base, and from federal emergency agencies who provide support to both property owners and to municipal governments. There are a number of other characteristics municipal governments may have that help enable them to maintain strong credit quality even after a storm has passed:

  • Tax/Revenue Base Size, Diversification and Population Stability: Large, diverse tax bases, such as a state or a large county or city, should feel a relatively smaller financial impact from storm damage than a smaller more concentrated tax base, such as a land-backed tax increment or a special assessment district, which could be wiped out by a storm. A stable population base with adequate resources is also more likely to rebuild the tax base after the storm than a population with fewer resources.
  • Security Pledge, Coverage Levels and Bondholder Protections: The type of security backing a muni bond, the level of tax or revenues, and bondholder protections like strong additional bonds tests and debt service reserves can provide adequate cushion to maintain strong credit quality. For example, a local government’s unlimited tax general obligation pledge will provide more security and a greater ability to raise revenues than appropriation backed debt, which typically does not have a dedicated source of revenue. Bonds backed by sales tax revenues, for example, could benefit from revenues generated from the purchase of goods used for rebuilding, while taxes from hotels could be delayed if hotel facilities remain closed or tourists are discouraged from visiting the storm area.
  • Management/Policy: Good management procedures and policies may be reflected not only by emergency preparedness, but also by a track record of maintaining and improving infrastructure, and building financial reserves that could provide a cushion during a period of rebuilding.

While many municipalities have been able to weather the storm, not all credits are created equal, and a combination of storm location and intensity and a lack of financial cushion have provided evidence of weaker credits’ vulnerability to natural disasters, including hurricanes. The combination of an intense storm and weak credit characteristics can lead to prolonged recovery and rebuilding, which in turn can cause downgrades or defaults. Comparing New York City and New Orleans provides an example of differing credit impacts from hurricanes. Both cities suffered severe damage, New York from Hurricane Sandy in 2012, and New Orleans from Hurricane Katrina in 2005, but the credit impact was far less severe for NYC. Both storms were intense, though Sandy only reached Level 3 while Katrina hit Level 5, but there were other factors that helped New York maintain its ratings. New York appeared to be better prepared, and its larger, more diverse and much stronger underlying economy, as well as its stable population, contributed to maintaining its tax base. New Orleans was already a relatively weak, BBB rated credit before Katrina hit, and it was downgraded to non-investment grade after the storm. Nearly twelve years later, a period that includes one of the longest periods of national economic growth, the population of the city is still below its pre-Katrina level. As it continues its slow recovery, New Orleans has been upgraded to low A rating category levels.

Beyond understanding the hurricane risks to each Muni sector and to individual Muni credits, we also want to ensure that our portfolios are adequately diversified. We believe that managing hurricane risk goes beyond sector and security diversification. We also want to make sure that credits are not concentrated in any one region in hurricane risk areas. A portfolio that holds a local GO, a dedicated tax bond, an airport, a higher ed, a hospital, a public power system, a toll road, and a water system would appear to be diversified, but if each of those names were located in one region, like in New York City, New Orleans, or another hurricane prone metro area, then the credits would be correlated and not properly diversified from hurricane risk. We will continue to review muni-based portfolios to ensure that they have proper sector, credit and regional diversification to mitigate hurricane risk. 

Source: Fitch Ratings and Moody’s Ratings

Is Inflation Crying wolf?

The ECB met last week on Thursday and left its main policy rate unchanged along with its asset purchase program. Members also reiterated their intent to reduce the pace of purchases in April from 80 billion Euros per month to 60. Mario Draghi was more optimistic during his subsequent press conference than he has been after recent ECB meetings, and noted the balance of risks had improved. The ECB committed last year to maintaining purchases through the end of 2017, which has caused some to speculate that the policy rate could be lifted prior to a wind down of the current purchase program, especially given that year-over-year headline inflation has risen materially in the past two months. Headline inflation for the Eurozone printed at 1.8% in January and 2% in February, which is just above the ECB’s stated goal. Despite this, medium term inflation forecasts were little changed, and Draghi pointed to still low core inflation (0.9%) along with rising geopolitical risks as reasons to be cautious in reducing policy accommodation. 

The Federal Reserve, meanwhile, is expected with near certainty to raise the federal funds rate another 0.25% at its meeting this week as the domestic expansion marches on. While global economic growth forecasts have ticked up, forecasts for first quarter growth in the U.S. are falling. The Atlanta Fed’s GDPNow model is currently predicting 1.2% quarter-over-quarter annualized growth, down from 2.5% less than a month ago. 

Headline inflation in both the Eurozone and the U.S. have made material gains recently, but those have been driven largely by energy costs (oil prices), which rose for most of last year, but are actually down about 10% YTD. This means that unless they start rising again, later this year we will see a drop off in the headline inflation figure for both the U.S. and Europe. The core inflation figures have lagged the headline number for both (charts below) and, given the modest growth outlook, may not catch up. Inflation is a key determinant of the level of longer-term interest rates, and developments in the commodities and labor markets will play a large role in the direction of both. While labor markets have improved, especially in the U.S., and growth has been fairly consistent, thereby helping commodities prices off their lows, materially higher rates would likely derail these trends. This self-limiting dynamic leaves us skeptical that inflation or rates will be taking off over the medium term.

Five Years of Euro Inflation (CPI - white is Headline and orange is Core):

Five Years of U.S. Inflation (PCE - white is Headline and orange is Core):

Source: Bloomberg, Atlanta Fed

February Jobs Report – We’re Finally Here, but Where Are We Going?

Well, we’re here! Friday’s job report indicates that 235K jobs were created. The first full job report under President Trump beat many expectations and is both roughly in line with the 3-year average and slightly above the 3- and 6-month averages. Almost every sector of the economy added jobs except the retail sector, which Barclays believes is due to ecommerce pressuring the traditional brick and mortar retail sector of the economy. It’s been a long road. We are now in the third longest economic expansion on record, and the FOMC looks poised to raise the federal funds rate at its meeting this week. The unemployment rate sits at 4.7%, a tick lower than last month, and the labor market appears sufficiently tight to create some wage pressure. Average hourly earnings for all employees increased 2.8% year-over-year, which is consistent with the last few years. But where are we going? A bullish economic case is one where the current job growth trend continues and monetary policy stimulus is replaced with fiscal and regulatory stimulus that would continue the economic expansion. The bear economic case is filled with domestic and foreign political uncertainty, which could upend the current positive economic trends and delay any fiscal and regulatory stimulus. Both scenarios seem equally likely. In this environment SNWAM is maintaining our current risk profile across all strategies, but keeping an open mind about selectively adding credit risk where we believe we can be appropriately compensated.

Source: Barclays Research, WSJ, Bureau of Labor Statistics and SNWAM