In this week’s Market Insights, we cover the FOMC meeting and volatility within the equity market, the recent upward movement in U.S. Treasury yields, and the modestly rising credit spreads. In our Chart of the Week, we discuss the municipal bond market and current valuations. Finally, we highlight the Federal Reserve’s balance sheet and its future composition.
- Federal Reserve (Fed) jitters contributing to volatile equity market – The S&P 500 was down nearly 9% through January 26. The VIX index had risen for six consecutive days, reaching an eleventh month high before pulling back last Tuesday. Escalating geopolitical risks between the U.S. and Russia over Ukraine are certainly weighing on risk sentiment, although monetary policy and inflation seem to be front and center. Investor concerns are growing that today’s abnormally high inflation will lead to a more hawkish Fed – to the tune of four to five rate hikes this year, a negative for long-term economic growth. Last week the Fed held its first meeting of the year and didn’t push back on the market’s assertions. Chairman Powell reiterated prior guidance that the Fed will use its tools to prevent inflation from spiraling out of control and hinted that rate hikes are coming as early as March. However, we believe that slowing, but still above average economic growth combined with improved demand/supply imbalances will weigh on inflation during the year and ultimately lead to a less aggressive policy response from the Fed. We continue to believe Fed policy will support long-term economic growth and that negative equity market sentiment will ultimately reverse.
- U.S. Treasury yields on the move – Bond yields have been trending higher throughout the year with the 10-year U.S. Treasury reaching 1.86% last Wednesday, 35 basis points (0.35%) higher on the year. What’s interesting is that the increase has coincided with sub-par U.S. economic growth. Retail sales, reported earlier in the month, declined in December while mostly stagnant in November. The Markit US Manufacturing and Markit US Services PMI data both came in weaker than expected last week as the IMF was downgrading its U.S. growth forecast for this year from 5.2% to 4.00%. However, the Treasury market seems to be solely focused on the Fed with yields rising alongside expectations of the rate hikes referenced above. Heading into the year, we believed yields would trend higher due to above-average growth and less accommodation from the Fed. It’s important to keep in mind that yields rarely move in a straight line and pull-backs should be expected. Most importantly, if the inflationary environment improves this year, as we believe it will, the need for aggressive Fed action will likely subside, letting some of the steam out of today’s run-up in yields.
- Credit spreads higher but controlled – Investment grade corporate spreads have risen 10 basis points (0.10%) this year coinciding with increased risk aversion in the equity markets. The additional yield compensation over U.S. governments for corporate bonds was at 92 basis points (0.92%) through January 24. Importantly, although trending higher, credit spreads remain below their 10-year average and well behaved in light of the equity market volatility. Interestingly, credit spreads have also absorbed healthy corporate issuance this year with firms looking to get ahead of potentially higher financing costs. Heading into 2022, we believed corporate spreads would be more volatile based on valuations and uncertainty regarding the future path of inflation and monetary policy. However, we also believed above average economic growth would be supportive for corporate profitability. Combined with healthy corporate balance sheets and our expectations for a continued strong labor market, we continue to look beyond today’s volatility and favor an overweight position to investment grade corporate bonds relative to U.S. government securities.
|Russell 1000 Value||(3.1)||(4.5)||17.2||13.49||9.78||1.89|
|Russell 1000 Growth||(5.2)||(13.5)||6.9||24.86||20.78||0.72|
|MSCI EM (Emerging Markets)||(2.3)||(1.6)||(10.6)||8.27||8.56||2.38*|
|Fixed Income||Week||YTD||1-Year||3-Year||5-Year||Div Yield|
|Bloomberg Barclays US Aggregate||(0.3)||(2.4)||(3.4)||3.83||3.08||2.14|
|Bloomberg Barclays US High Yield – Corporate||(0.7)||(1.9)||2.8||6.81||5.59||4.98|
|Bloomberg Barclays Municipal Bond||(0.7)||(1.9)||(0.9)||3.96||3.70||1.53|
|Bloomberg Barclays Global Aggregate x US (Country)||(0.2)||(1.1)||(6.9)||2.15||2.90||1.19|
|Crude Oil WTI (NYM $/bbl) Continuous||1.8||16.1||66.0||17.6||10.2||87.4|
|Natural Gas (NYM $/mmbtu) Continuous||5.0||13.1||53.1||9.5||3.5||4.0|
|Gold NYMEX Near Term ($/ozt)||(0.7)||0.1||(1.1)||12.1||9.0||1,829.9|
|Copper Cash Official LME ($/mt)||1.7||2.8||25.2||19.1||11.1||9,965.0|
|Currencies||1 Week Ago||YTD||1-Year Ago||3-Years Ago||5-Years Ago||Current Level|
|U.S. Dollar per Euro||1.13||1.14||1.22||1.14||1.07||1.13|
|Japanese Yen per U.S. Dollar||114.34||115.16||103.65||109.68||114.75||114.33|
|U.S. Dollar per British Pounds||1.36||1.35||1.37||1.32||1.26||1.35|
Chart of the Week
AAA Municipal Bond Yield as a % of U.S. Treasury Bond Yield – 5 Year Maturity (June 30, 2021 – January 21, 2022)
Investor demand for tax-free municipal bonds remained robust in 2021 given strong underlying fundamentals, uncertainty around future tax policy, and the allure of tax-free income. The December 31, 2021 valuations notably reflected a healthy municipal bond market. The above chart compares the 5-year AAA municipal yield to the 5-year U.S. Treasury yield. A lower ratio indicates municipal bond demand outpacing that of U.S. Treasury securities.
In 2022, as noted by the chart, municipal valuations have eased and are trading at their cheapest levels in more than six months. 5-year AAA municipal yields have increased over 30 basis points this year (0.30%) and closed at 0.94% on January 21.
Importantly, in our view, credit quality remains strong. State coffers continue to benefit from a hot housing market and solid U.S. economic growth leading to healthy sales and income tax revenue. Importantly, an unprecedented amount of fiscal aid from Congress to the tune of $350 billion via the 2021 American Rescue Plan will continue to benefit city and state’s reserve fund’s this year.
We certainly welcome the higher-yielding environment for investing in municipal bonds this year. The 5-year area is noteworthy given the recent rise in yields and its duration characteristics. Combined with healthy issuer fundamentals, we believe the cheaper valuations provide a good opportunity to put excess cash to work.
Federal Reserve Banks Total Assets (December 31, 2019 – January 19, 2022)
The Federal Reserve balance sheet has ballooned to nearly $9 trillion, more than doubling in roughly two years. With the Federal Reserve shifting gears from looser to tighter monetary policy this year, the balance sheet has quickly become a hot investor topic. Why? A shrinking balance sheet means less Fed government bond-buying, a potential tailwind for U.S. Treasury yields given less bond demand. We would agree that upward pressure on yields is certainly possible but would stop short of anticipating any “taper tantrum” sized moves.
The Fed’s preferred measure to conducting monetary policy is the federal fund’s target range – adjusting it higher/lower depending on the economic outlook. The balance sheet provided extra ammo through the early parts of the recent economic recovery and expansion, but the need for further action has diminished. The likely course of Fed action is to let bonds mature, gradually reducing the size of the balance sheet over time. We don’t foresee a need for any premature selling on the simple basis that it’s never been tested and could potentially lead to disruptive market functioning, an environment the Fed will likely try to avoid.