Markets see rate hikes coming sooner with still-raging inflation

Municipals were little changed with barely a trade to point to, keeping with the trend of sitting on the sidelines while U.S. Treasuries saw losses, more so out long, and equities made gains.

Triple-A benchmarks were left unchanged and ratios were slightly lower on the moves in UST. The five-year was at 47%, 69% in 10 and 78% in 30, according to Refinitiv MMD’s 1 p.m. read. ICE Data Services had the five at 46%, the 10 at 71% and the 30 at 78%.

Supply next week barely registers, with about $12 million on the calendar — $11.9 million of negotiated transactions and $300,000 of competitive loans.

Thirty-day visible supply sits at $3.4 billion with $1.749 billion of competitive loans and $1.655 billion of negotiated on the docket. Bloomberg data shows $13.269 billion of net-negative supply with the largest supply deficits from Illinois at negative $2.227 billion, California at negative $1.839 billion and New York issuers with negative $1.668 billion.

The markets see rate hikes coming sooner as a result of still-raging inflation. “Fed rate hike expectations continue to heat up as the chances of March 16th hike grow,” said Edward Moya, senior market analyst at OANDA. “The consensus on Wall Street is that inflation is still not at its peak, so by the time we get to the end of January, a March rate hike may fully be priced in.”

What that might mean for municipals is that as issuers contemplate the rising-rate environment, any potential rate hikes that hit sooner than expected may push some taxable refundings up into January and February to lock in the lower rates.

Taxable issuance saw an uptick in December as issuers came to understand tax-exempt advance refundings were not coming back.

Total issuance in December through the 20th was $35.115 billion versus $34.822 billion total in December 2020, per Refinitiv. Of the December 2021 total, $10.742 billion was taxable and $23.009 billion exempt.

Many analysts already expect some increase in taxables to start the year, but if the rate hike signals from the Fed are clearer, that increase could be larger.

Secondary trading was very thin, down 75% from Wednesday, which was already skimpy at a total of $6.3 billion par value. California 5s of 2022 at 0.10%-0.09%. New York Dorm PITs 5s of 2022 at 0.095%. New York City TFA 5s of 2029 at 1.03%-1.02%. San Francisco City and County COPs 5s of 2029 at 0.92%. California water 5s of 2031 at 0.97%. Michigan Trunkline 5s of 2034 at 1.26%.

A look at 2021 ratio trends
There have been periods in 2021 when fair value emerged on tighter UST levels and wider muni yields, noted Kim Olsan, senior vice president at FHN Financial.

An uptick in supply during February and into early March versus moderate reinvestment needs pushed muni yields up in a supply/demand mismatch, she noted.

The 10-year AAA traded to the 1.10% area from below 0.70% at the start of the year, correcting at a faster clip than the 10-year UST during that period. Olsan said that relative value rose to over 80%/UST in that cycle, “which happens to be the highest ratio of the year.”

October’s trading brought a similar opportunity when the 10-year AAA sold off to over 1.20% while the UST held in a tighter range.

“Over this year, the average ratio is 67% but in the last five years the ratio has run at 89%,” she said.

Long-end munis in 2021 have presented similar wider periods, but at different times this year.

“The 2021 high 30-year AAA/UST ratio is 88% from earlier this month when a risk-off trade took hold that municipals didn’t participate in at the time,” she said. “Corresponding yields were 1.48% (UST 30-year AAA) to 1.67% (long bond). Over certain cycles this year this ratio has held above 80% as munis lag a UST rally. This year’s median ratio is 75%, while the 5-year average is 95%.”

Looking ahead to 2022, Olsan said, a main intermarket input is higher supply/lower demand cycles that can skew muni rates higher during certain months of year.

“Over the last year, there have been more definitive absolute yield ranges in the 10- and 30-year spots that can signal better relative value,” she said. “For the 10-year AAA, it’s a range over 1.10% and in the 30-year area any yield over 1.60% — or when the gap between the AAA spot and UST is about 40 basis points or less.”

Economy
While economic data released Thursday showed strength, there is a caveat.

“It is important to note that much of the data coming out reflects the world before the onset of Omicron and its rapid spread,” said Grant Thornton Chief Economist Diane Swonk and Economist Yelena Maleyev. “Financial markets have begun to react to the uncertainty surrounding the new variant, which is overtaking Delta in other countries and looks poised to do the same here.”

While the data show “the economy was running on all cylinders in the fourth quarter,” they said, the impact from Omicron has yet to be felt. “Some of the weakness could show up in data for December, but the bulk of the weakness will show up as canceled events, travel and less spending on services in January.”

Perhaps the numbers most important to the municipal market were inflation data from the personal income and spending report. While income rose 0.4% in November and spending gained 0.6%, both as projected by economists polled by IFR Markets.

The personal consumption expenditures index, the Fed’s favorite gauge of inflation, climbed 0.6% in the month and is up 5.7% from a year ago, the largest gain since the 12 months ended July 1982. The core PCE increased 0.5% in the month and 4.7% for the year, the fastest pace since 1989.

The increases were “broad-based, which has raised red flags at the Federal Reserve,” they said. “The consensus among members of the Fed is that variants are more disruptive to supply chains, including labor, than to demand and, therefore, more inflationary.”

More bad news: when adjusted for inflation, personal disposable income dropped 0.2% in November, “the fourth consecutive inflation adjusted drop in a row,” Swonk and Maleyev noted.

Also released on Thursday, the University of Michigan’s final December consumer sentiment index rose to 70.6 from 70.4 mid-month and 67.4 in November. The current conditions index climbed to 74.2 from 73.6 in November, while the expectations index rose to 68.3 from 63.5 in November. All three indexes are below last year’s levels.

While the numbers remain low, they suggest consumers have become “more optimistic and inflation expectations edged lower,” Moya said.

Separately, initial jobless claims held at 205,000 in the week ended Dec. 18, while continuing claims slipped to 1.859 million in the week ended Dec. 11 from 1.867 million a week earlier.

Also released, durable goods orders rose 2.5% in November, compared to expectations for a 1.5% climb, while excluding transportation orders increased 0.8% in the month.

Additionally, new home sales jumped 12.4% to a 744,000 pace in November, while the median price grew to $416,900 from $408,700 and the average price gained to $481,700 from $478,200.

“Despite the increase in sales, housing affordability remains a major concern,” according to Danushka Nanyakkara-Skillington, National Association of Home Builders Assistant Vice President of Forecasting and Analysis.

“Our members are seeing strong buyer traffic as continued low mortgage rates are helping fuel sales,” noted Chuck Fowke, NAHB chairman. “However, builders are still grappling with major supply chain issues and soaring materials costs, which are causing construction delays.”

Wells Fargo Securities economists, in a report said, “The economic data this week were not without a few disappointments, but for the most part, it appears that Omicron’s effect on the economy so far is to slow it rather than stop it.”

They said, “inflation appears to be a bigger threat than the latest COVID variant, at least for now,” with price pressures at the highest levels since the 1980s. “While prices are certainly weighing on consumers’ mindset, neither inflation nor Omicron has completely rattled nerves.”

AAA scales
Refinitiv MMD’s scale was unchanged: the one-year at 0.14% and 0.24% in 2023. The 10-year sat at 1.03% and at 1.48% in 30.

The ICE municipal yield curve showed yields were little changed: 0.15% in 2022 and 0.27% in 2023. The 10-year steady at 1.04% and the 30-year yield at 1.49%.

The IHS Markit municipal analytics curve was steady: 0.16% in 2022 and to 0.25% in 2023. The 10-year at 1.01% and the 30-year at 1.48% as of a 3 p.m. read.

Bloomberg BVAL was unchanged: 0.17% in 2022 and 0.22% in 2023. The 10-year was at 1.04% and the 30-year at 1.48%.

Treasuries were weaker while equities improved.

The five-year UST was yielding 1.243%, the 10-year yielding 1.494%, the 20-year at 1.933% and the 30-year Treasury was yielding 1.907% at 2:30 p.m. eastern. The Dow Jones Industrial Average gained 280 points, or 0.78%, the S&P was up 0.81% while the Nasdaq gained 0.99% at 2:30 p.m. eastern.