Short munis still under pressure, but lower inflation figure spurs market optimism


Municipals continued to see large cuts on the short end Tuesday as selling pressure there remained elevated but the rest of the curve improved following a better-than-expected consumer price index report that led to a rally in U.S. Treasuries. Equities ended the session in the black.

The one-year triple-A muni ended the session with up to 10 basis point cuts and up to four basis point bumps on bonds five years and out. U.S. Treasury yields fell up to 18 on the short end.

The three-year muni-UST ratio was at 61%, the five-year at 67%, the 10-year at 71% and the 30-year at 97%, according to Refinitiv MMD’s 3 p.m. read. ICE Data Services had the three at 59%, the five at 63%, the 10 at 72% and the 30 at 96% at a 4 p.m. read. 

The CPI report showed inflation had slowed to 7.1%, giving investors confidence the Federal Open Market Committee will hike rates 50 basis points as expected following Wednesday’s much-anticipated meeting.

The data showed that U.S. consumer prices barely rose last month amid declines in the cost of gasoline and used cars, leading to the smallest annual increase in inflation in nearly a year.

The U.S. Labor Department’s report showed consumer prices increased by 7.1% annually in November, while the core rate, which excludes volatile food and energy prices, climbed 6.0%. Economists were expecting a 7.3% rise in headline CPI and a 6.1% rise in core rates.

“The numbers were better than expected across the board,” said Craig Brothers, portfolio manager and head of fixed income at Bel Air Investments in Los Angeles. “What the bond market liked most is the month-over-month numbers” he said, pointing to the Core CPI, which rose 0.2% this month after rising 0.3% last month.

“The deceleration of core inflation looks like more of a trend, so the bond market rallied like crazy first thing this morning, even though we’re giving back a little bit of it now,” Brothers said Tuesday midday.

“I thought we had a chance for one more move up in yield — if CPI came in a hair hot — but the fact that this is more consumer related and did beat the numbers across the board, that kind of opens the door for thinking that inflation is somewhat under control,” Brothers said.

At the same time, however, he doesn’t expect inflation to fall to the Federal Reserve Board’s 2% target anytime soon.

He observed some weakness the last two days as cautious investors patiently awaited the CPI data, and still have their eyes on the Fed’s policy meeting scheduled for Wednesday heading into the final weeks of what was a challenging year, Brothers said.

“We’re starting to see more bid lists come out and I think the bidding, to me, feels like it’s more defensive than it was last week,” he said.

“December money from coupons and redemptions is mostly spent, so I wouldn’t be surprised by seeing some weakness being that the bidders were being really patient,” ahead of the latest CPI results, he added.

He referred to the current economic scenario “a quasi Goldilocks situation.”

“Inflation will be a little more stubborn and we’ll start to see job losses pick up,” he said. “I’m more in the camp that it’s likely not going to be a hard landing — I am not ruling it out — but I am ruling out a soft landing.”

The new data helps fuel the Fed’s decision on interest rates Wednesday, Brothers noted.

“Given the amount of inflation in the system, the stickiness of wages and energy prices, and the likelihood of China reopening, lots of things make the Fed’s job difficult,” he said.

Brothers said the Fed heavily weighs the results of the CPI because consumers are most aware of the data that affects them when it comes to rent and food prices, for instance.

Now, he said, the market “is trying to front-run a Fed pivot” and “dying for information and data points” to provide some direction on future inflation.

Overall, Brothers said he feels like the market is on its heels right now.

“To keep the rally going you need the bidders, traders, and portfolio managers to believe the rates are going lower,” he said.

The ongoing dearth of new-issue supply has forced attention to the secondary market for paper and supported a muni rally.

“Lack of new-issue supply has been a major vector here, in particular with customer sales and total trade volumes jumping — the latter showing its biggest week in seven months — on tax swap FOMO before [Dec. 31],” said Matt Fabian, a partner at Municipal Market Analytics.

But with “an atypically low year-end bump in primary market supply” tax swappers are focused on the secondary and exchange-traded funds for their reinvestment, he said.

He said “dealers have prepared for the former, boosting inventories to their highest in seven months,” especially longer maturities.

Exchange-traded funds”have no issue with inflows — putting cash to work at whatever evaluations allow — but note that, seeing particular growth at the short-term SUB fund, ETF manager expectations should be that current inflows at all strategies may be more temporary (i.e., cash alternative biased) than typical,” he said.

“This — meaning hypothetical future trading out of ‘cash’ ETF holdings to more permanent allocations — may muffle market strength at some point in the future,” he said, but reasonably not before the end of the year.

It may also push ETF buyers to “overrepresent front end purchases to the extent tolerated by their strategies/prospectuses,” according to Fabian.

For the issuance that did come in the primary, “bonds saw solid breaks to lower yields, highlighting the breadth of demand,” he said.

In the primary Tuesday, Wells Fargo Bank priced for the Pennsylvania Economic Development Financing Authority (Baa2//BBB-/) $1.775 billion of tax-exempt AMT Penndot Major Bridges Package One Project private activity revenue bonds, with 5s of 12/2029 at 3.81%, 5s of 6/2032 at 3.96%< 5s of 12/2032 at 4.00%, 5s of 6/2037 at 4.58%, 5.5s of 6/2042 at 4.57%, 5.75s of 6/2048 at 5.04%, 5s of 12/2057 at 5.08% and 5.75s of 12/2062 at 5.16%, callable 12/31/2032.

Assured Guaranty insured $576.405 million of the deal.

AAA scales
Refinitiv MMD’s scale was cut 10 basis points at one-year: the one-year at 2.61% (+10) and 2.46% (unch) in two years. The five-year at 2.43% (-4), the 10-year at 2.47% (-4) and the 30-year at 3.42% (-4).

The ICE AAA yield curve was cut on the short end: 2.61% (+11) in 2023 and 2.49% (+3) in 2024. The five-year at 2.45% (-4), the 10-year was at 2.55% (-5) and the 30-year yield was at 3.43% (-4) at 4 p.m.

The IHS Markit municipal curve saw large cuts on the short end: 2.59% (+10) in 2023 and 2.46% (unch) in 2024. The five-year was at 2.45% (-4), the 10-year was at 2.49% (-4) and the 30-year yield was at 3.41% (-4) at a 4 p.m. read.

Bloomberg BVAL was bumped outside of the one-year: 2.57% (+6) in 2023 and 2.47% (-1) in 2024. The five-year at 2.44% (-3), the 10-year at 2.52% (-5) and the 30-year at 3.42% (-3) at 4 p.m.

Treasuries rallied.

The two-year UST was yielding 4.233% (-15), the three-year was at 3.962% (-18), the five-year at 3.659% (-13), the seven-year 3.604% (-13), the 10-year yielding 3.516% (-9), the 20-year at 3.752% (-6) and the 30-year Treasury was yielding 3.542% (-3) at the close.

CPI data shows inflation cooling
Tuesday’s inflation report is a “welcome holiday gift to markets,” said Matt Peron, director of research at Janus Henderson Investors.

“While inflation is still unacceptably high, it is clearly dropping due to the lag effect of the rate hikes implemented this year,” he said. “This aligns with what we hear from management teams in that the inflationary pressures are loosening.”

“Headline CPI has been moderating but the core component remains stubbornly high lending fuel to the Fed’s policy of raising rates to fight off the worst US inflation since the 1970s,” said Arthur Laffer, president of Laffer Tengler Investments.

Tuesday’s CPI report “offers further evidence that core inflation is slowing and that the peak in inflation this cycle is behind us,” said Wells Fargo Securities Senior Economist Sarah House and Economist Michael Pugliese..

“A directionally slower but still elevated core inflation rate argues for a directionally slower but still aggressive monetary policy response, and that is what we expect from the FOMC tomorrow,” House and Pugliese said. “A 50 bps rate hike is all but assured, and such a move would be a step down from the 75 bps pace that marked the previous four FOMC meetings.”

“Soft U.S. inflation will reinforce the view that the interest rate peak is in sight, but having been hurt by the ‘inflation is transitory’ narrative, the Fed will be wary about a conviction call in this environment,” said James Knightley, ING’s Chief International Economist. “50bp is still the call tomorrow, but there’s less chance of a rate above 5% in 2023. Recessionary forces will mean rate cuts are on the agenda in 2H23.”

Josh Jamner, an investment strategy analyst at ClearBridge Investments, concurred, saying the since the CPI was again soft this month, it “should lock-in the Fed for a 50 bps rate hike tomorrow.”

Phillip Neuhart, director of market and economic research at First Citizens Bank Wealth Management, said the CPI report is “good news for markets and the Federal Reserve. Should this downtrend persist, it allows the Fed to slow the pace of interest rate hikes and eventually pause in the first half of next year,” he said.

The CPI convincingly missed to the downside for the second consecutive month, “providing much-needed relief in what has been and largely remains uncomfortably high inflation,” said Marvin Loh, senior global macro strategist at State Street

“The overall reading remains too high, but a second solid miss affirms the Fed’s view that it is now time to slow the pace of hikes,” he said.

And with two consecutive months of slowing inflation, “the market seems likely to run with the trend which would be supportive of a modestly earlier end to rate hikes, coming in 1Q instead of in 2Q (potentially),” Jammer said.

He said he “would likely need to see the trend continue in early 2023 for this to occur, which isn’t guaranteed, particularly given the re-acceleration in producer prices seen last week along with sustained elevated wage gains.”

José Torres, a senior economist at Interactive Brokers, said on top of mind Wednesday “will be how high the Fed’s dot plot indicates it will need to go and how long it needs to stay there to bring inflation down to its 2% target.”

With those concerns in mind, he said Powell may use Wednesday’s “press conference to re-anchor market expectations rather than allow sentiment to strengthen, similar to the Jackson Hole speech last August.”

In doing so, Torres notes Powell “will face the difficult task of striking a balance between tamping down investors’ expectations without sounding overly pessimistic.”

“On the other hand, shades of dovishness will likely propel the market higher and yields lower which would be similar to market reactions following some of his past presentations, including his November speech at the Brookings Institution,” he said.

Loh still expects the Fed to raise rates by 50 bps and continue to “signal the need to remain vigilant on the inflation front, that includes continued hikes into 2023.” His estimates is that “this will include a 5.125% terminal rate, which will be accomplished with 50 bps in February and a final 25 in March, at which point the Fed will pause to allow the cumulative and lagged impact of rate hikes to work their way through the economy.”

For the moment, Loh said the “Fed will continue to signal inflation vigilance, which we think means 50 bps tomorrow and two more hikes totaling 75 bps through March 2023.”

“The jobs market remains too hot and wage inflation at 5.5% per the last jobs report is inconsistent with its 2% inflation target,” he said, noting he does not think “this will cause too much concern for the market.” However, “how long the Fed expects to stay in restrictive territory may be the biggest hurdle for a market that is pricing an aggressive pivot,” he said.

“Continued data like this CPI report will make it harder for the Fed to contain these pivot expectations, so we think it will try to sound hawkish this week, although the tide is clearly starting to turn on the inflation front,” Loh said.

Wednesday’s reduction in the pace of tightening to 50bps “was already telegraphed, and with the downtrend in inflation becoming entrenched, the FOMC can set its sights squarely on the labor market,” Morgan Stanley strategists said.

They forecast a “slowdown in jobs growth over the coming months sets the stage for, first, a further step down to a 25bp increase in the February meeting.”

As jobs growth trends toward the 100,000 mark, Morgan Stanley “expect no further interest rate hikes at the March FOMC, leaving the peak fed funds rate at 4.625%.”

However, Jammer said, “the slowdown in inflation appears to be more driven by post-pandemic normalization (finally) playing out more so than it looks like the 425 bps of rate hikes (including tomorrow’s likely 50 bps increase) the Fed has implemented taking effect.”

“This is actually fairly concerning, because the lagged effects of Fed tightening are still looming in 2023 and the economy appears to be slowing on its own, lending to elevated recession risks in our view in the coming year,” according to Jammer.

Primary to come:
The Idaho Housing and Finance Association (Aa1///) is set to price Thursday $253.615 million of taxable single-family mortgage bonds, 2022 Series A, serials 2023-2035, terms 2038, 2043, 2048 and 2053. Barclays Capital.

The Clearview Regional High School District Board of Education, New Jersey (/AA//) is set to sell $59.094 million of school bonds, Series 2022, at 11 a.m. eastern Wednesday.

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