Munis firmer, UST rally after CPI shows inflation cooling
8 min read
Municipals were firmer Thursday as inflows into muni mutual funds returned and triple-A benchmarks continued to fall, underperforming a U.S. Treasury rally after the consumer price index report showed inflation is cooling. Equities ended up.
The three-year muni-UST ratio was at 58%, the five-year at 62%, the 10-year at 68% and the 30-year at 91%, according to Refinitiv MMD’s final 3 p.m. ET read. ICE Data Services had the three at 57%, the five at 60%, the 10 at 67% and the 30 at 89% at a 4 p.m. read.
Attractive municipal yields and ratios were giving buy-side investors an increased comfort level on Thursday, according to Anthony Valeri, director of investment management at Zions Wealth Management.
Even though he remains cautious ahead of potential interest rate changes, the current market is proving fruitful for those interested in higher returns and protection from rate volatility.
“The jump in yields witnessed last year puts investors on much better footing for the coming year,” he said.
Valeri noted yields on the average 10-year triple-A-rated benchmark more than doubled, while the average yields on a two-year, triple-A-rated municipal has more than quadrupled in many cases.
“The extra yield is not only an attractive source of tax-exempt income but provides a much bigger buffer against potential price declines” should interest rates go up, he said.
Inflows returned as Refinitiv Lipper reported $1.981 billion was added to municipal bond mutual funds in the week ending Wednesday after $2.477 billion of outflows the week prior.
High-yield saw $916.674 million of inflows after $765.117 million of outflows the week prior, while exchange-traded funds saw inflows of $454.130 million after $621.036 million of inflows the previous week.
“The muni market entered 2023 on the expensive side relative to Treasuries as evidenced by some of the lowest muni-to-Treasury yield ratios of the past 12 months,” he said.
In a “historically difficult” year, municipals outperformed relative to most taxable bonds in 2022, according to Valeri, who said he doesn’t expect to see much change in the valuations over the near term given reinvestment needs and tight supply.
“Both taxable and tax-exempt markets have been supported in recent weeks and months by expectations of a Fed pivot — a halting of rate hikes with a shift to rate cuts later in 2023,” Valeri said.
He called those expectations “premature.”
Should inflation remain stubborn, Valeri said, “the rate cuts priced into the market and reflected by lower yields of the last few weeks may disappear, which would put price pressure on municipal bonds.”
Munis “continue to exhibit strength in generic high-grade structures and the sub-5% coupon stack,” said Kim Olsan, senior vice president of municipal bond trading at FHN Financial.
Benchmark gains “have a main muni index up nearly 2% this month, tracking a UST index but lagging a U.S. corporate index by 100 basis points,” she said, noting the “growing prevalence of 3s and 4s among bid lists and secondary offer situations.”
“A sale of PSF (Aa2/NR) Mansfield, Texas, Independent School 3s due 2036 at 3.59% came with a spread of +75/MMD, or about 50 basis points through its evaluated price at the market lows from late October,” she said.
“An item posted on a larger bid list containing short-dated calls included $5 million Aaa/AAA Florida GO 4s due 2031 (callable 2026) which traded +27/MMD, a compression of about 10 basis points from comparable trades” a few days earlier, Olsan said.
“Part of the newfound push to lower yields and spreads is a piggyback move on the broader inflation-is-easing theme,” she said, “but specific to munis it’s also a function of a still-limited calendar which has to reach a typical $6 billion or higher weekly figure.”
Current levels, she said, “suggest relative value has faded in the first third of the curve,” but valuable ratios are still in play.
When the pandemic started in 2020, she said, “there was a brief period when rates spiked on uncertain economic fallout with lockdowns.”
“The ensuing low rate cycle brought on by federal stimulus and strong spending in certain categories offered minimal incentives,” Olsan said. “Short-term TEYs were held below 50 basis points while intermediate and long munis traded with TEYs under 2%.”
The market’s yield highs from October 2022, she said, “drew heavy buying with new range opportunities.”
During the month, daily bid were at $1.7 billion and secondary trades reached $14 billion daily, each around 20% higher than the daily average for the year.
“Intermediate MMD yields traded just below 3.50% for a decade-long high water mark,” she said.
“A rally into December [2022] took the yield to the 2.60% range for a TEY just shy of 4%. Long-term 5% AAA TEYs surpassed 5% for a net pickup to USTs of 100 basis points or more,” according to Olsan.
She said current levels have “removed value on the short end (more demand than supply can offer) but past five years TEYs remain favorable.” Both the 10- and 20-year MMD 5% spots offer “TEYs not that far off the October highs,” she said.
For additional value, she noted, “buyers have become re-enamored with lower coupon bonds where TEYs are boosted by 100 basis points or more.” Local Texas issuance, for instance, “in the 20-yeaer range offered yields near 4% for TEYs exceeding 6%,” Olsan said.
Secondary trading
NYC 5s of 2024 at 2.50%-2.47%. Seattle water 5 of 2025 at 2.33%-2.36% versus 2.42% Tuesday. California 5s of 2026 at 2.20% versus 2.25% Wednesday.
Triborough Bridge and Tunnel Authority 5s of 2029 at 2.40% versus 2.53%-2.46% Tuesday and 2.82%-2.68% original on 1/6. Harris County, Texas, 5s of 2032 at 2.40%-2.37% versus 2.64%-2.62% on 1/5. NYC TFA 5s of 2033 at 2.47%.
Austin water 5s of 2041 at 3.29%-3.28%. Washington 5s of 2043 at 3.43%-3.38%.
Massachusetts 5s of 2049 at 3,52%-3.50% versus 3.60% Tuesday and 3.80% on 1/4. NY State Environmental Facilities Corp. 5s of 2051 at 3.60%-3.62% versus 3.70%-3.52% Tuesday and 3.85% on 1/4. Massachusetts Bay Transportation Authority 5s of 2052 at 3.53%-3.52% versus 3.54% Tuesday.
AAA scales
Refinitiv MMD’s scale was bumped three to seven basis points: the one-year at 2.45% (-3) and 2.29% (-3) in two years. The five-year was at 2.20% (-7), the 10-year at 2.33% (-5) and the 30-year at 3.26% (-5).
The ICE AAA yield curve was bumped two to six basis points: at 2.44% (-2) in 2024 and 2.32% (-2) in 2025. The five-year was at 2.23% (-4), the 10-year was at 2.32% (-6) and the 30-year yield was at 3.29% (-5) at 4 p.m.
The IHS Markit municipal curve was bumped two to seven basis points: 2.46% (-2) in 2024 and 2.29% (-2) in 2025. The five-year was at 2.25% (-4), the 10-year was at 2.34% (-6) and the 30-year yield was at 3.26% (-7) at a 4 p.m. read.
Bloomberg BVAL was bumped three to six basis points: 2.44% (-3) in 2024 and 2.28% (-3) in 2025. The five-year at 2.22% (-5), the 10-year at 2.33% (-5) and the 30-year at 3.28% (-5).
Treasuries rallied.
The two-year UST was yielding 4.129% (-9), the three-year was at 3.716% (-12), the five-year at 3.521% (-13), the seven-year at 3.473% (-13), the 10-year at 3.427% (-12), the 20-year at 3.722% (-11) and the 30-year Treasury was yielding 3.550% (-11) at 4 p.m.
CPI comes in line with expectations
December’s consumer price index showed inflation softer than November, with the headline number down 0.1% in the month, but up 6.5% year-over-year, the smallest gain since October 2021 and down from 7.1% in November.
“Wall Street is feeling more confident about another downshift in tightening by the Fed,” said Edward Moya, senior market analyst at OANDA. “Disinflation trends are clearly intact as cheaper energy costs helped deliver the first month-over-month decline in 2 ½ years.”
Inflation, he said, “isn’t broadly coming down, but it is cooling as the economy starts to feel the impact of the Fed’s earlier rate hikes.”
“The market had priced in a very optimistic scenario about CPI in the previous days,” said Maria Vassalou, Co-Chief Investment Officer of Multi-Asset Solutions at Goldman Sachs Asset Management. “The numbers came in at exactly the expectations level. That means that some of the optimism in the markets may get unwound both in equities and fixed income.”
Consumer inflation “is clearly moderating from the 2022 peaks,” said Scott Anderson, chief economist at Bank of the West, “but the outsized impact of large one-off price declines in categories like gasoline, used cars, and airfares in December, suggest consumer inflation will likely accelerate a bit on an annualized basis in the first quarter of 2023, even as year-on-year inflation continues to moderate.”
Despite the slowing pace of inflation, Wells Fargo Securities Senior Economist Sarah House and Economist Michael Pugliese “doubt the FOMC is ready to declare mission accomplished.”
“U.S. inflation shows price pressures are easing, yet in an environment of a strong jobs market, the Federal Reserve will be wary of calling the top in interest rates,” said James Knightley, ING chief international economist.
“There have been head fakes on inflation before, to no avail, and there is a wide range of inflation outcomes between the peaks seen last summer and the central bank’s 2% inflation target,” House and Pugliese said. “Eventually the goods price deflation will cease, and labor cost growth continues to run in excess of what Fed officials believe is consistent with 2% inflation.”
“December marked a third consecutive month of softer inflation data, which will likely tilt the Fed towards our call of a 25bp rate hike” at its February FOMC meeting, said Mickey Levy and Mahmoud Abu Ghzalah of Berenberg Capital Markets.
House and Pugliese said the report “ups the chance that the FOMC will hike the fed funds rate by just 25 bps at its next meeting, but with the trend in inflation still above target, we expect that even if the FOMC delivers a downshift in pace, it will continue tightening past its next meeting.”
CPI offers “confirmation that the downshift in inflation pressures is becoming entrenched, setting the stage for another reduction in the pace of rate hikes at the upcoming February FOMC,” said Morgan Stanley Researchers.
Fed speakers, they noted, “have signaled to a preference for a step down to 25bp increments as the end of the tightening cycle comes closer.”
While the December FOMC’s SEP points to a higher peak rate, Morgan Stanley Researchers “continue to expect only one final 25bp rate hike before a pause and an eventual first rate cut in December.”
“The inflation data look consistent with our call, and more slowing in the two payrolls reports between now and the March meeting should move the Fed to an earlier end of tightening,” they said.
Anderson, who concurs about a 25 basis point rate hike in February, continues to “forecast 75 basis points of additional Fed rate hikes this year before a prolonged pause, with 25 basis point hikes at the February, March, and May FOMC meetings.”
And while the quarter-point hike is the likely outcome of the coming meeting, “the strength of housing in the core CPI and the benign jobless claims support the scenario of a 50bps hike,” said Vassalou.
“However, what matters most for the markets is the terminal Fed rate, not so much the pace of hikes,” she said. “As we get closer to the terminal rate, the pace of hikes needs to slow down.”
“The Federal Reserve will likely continue to tighten monetary policy, potentially at a slower pace,” said Phillip Neuhart, director of market and economic research at First Citizens Bank Wealth Management.
Mutual fund details
Refinitiv Lipper reported $1.981 billion of inflows for the week ended Wednesday following $2.477 billion of outflows the previous week.
Exchange-traded muni funds reported inflows of $454.130 million after inflows of $621.036 million in the previous week. Ex-ETFs, muni funds saw inflows of $1.527 billion after outflows of $3.098 billion in the prior week.
Long-term muni bond funds had inflows of $1.895 billion in the latest week after outflows of $1.763 billion in the previous week. Intermediate-term funds had inflows of $260.022 million after outflows of $455.954 million in the prior week.
National funds had inflows of $1.844 billion after outflows of $1.983 billion the previous week while high-yield muni funds reported inflows of $916.674 million after outflows of $765.117 million the week prior.
