Fed rate hike pushes 2-year UST above 4%; munis slow to respond

Bonds

Municipals were mixed after the Federal Open Market Committee implemented a third straight 75 basis point rate hike as it continues to combat inflation, pushing the two-year U.S. Treasury above 4% while the 10-, 20- and 30-year made gains. Equities ended in the red.

The FOMC raised the fed funds rate target 75 basis points to a range of 3% to 3.25%, as expected, and members are leaning toward a rate of 4.4% by yearend and 4.6% next year.

The post-meeting statement acknowledges upcoming hikes, saying the FOMC “anticipates that ongoing increases in the target range will be appropriate.”

The third jumbo hike in consecutive meetings “and the maintenance of references to broad-based price pressures and future hikes ahead underscore how the Fed is now singularly focused on trying to control inflation,” said Fitch Chief Economist Brian Coulton. And while Fitch expects a 4% rate target by yearend, he said, “this will be one of the fastest episodes of Fed tightening in the post-war period.”

D.A. Davidson’s Director of Wealth Management Research James Ragan said the 125 basis points of expected further hikes this year ”is likely to lead to modestly higher Treasury yields (especially at the short end of the yield curve-up to two years), while the longer end of the curve will more closely follow economic activity over the next few quarters. Weaker than expected GDP would stoke recession fears and likely lead to lower yields for the 10-year Treasury.”

Triple-A muni yield curves were left unchanged to a few basis points cheaper on the short end Wednesday as secondary activity was light following the FOMC news.

Two- and three-year muni-UST ratios are around 67% to 68%. The five-year on Wednesday was at 73%, the 10-year at 85% and the 30-year at 105%, according to Refinitiv MMD’s 3 p.m. read. ICE Data Services had the five at 73%, the 10 at 87% and the 30 at 102% at a 4 p.m. read.

“It is quite common for bond market volatility to remain engaged ahead of a scheduled Fed meeting with UST yields poised to move higher,” noted Jeff Lipton, managing director of credit research at Oppenheimer Inc.

The bond market was happy with the announcement, said David Petrosinelli, senior trader at InspereX, reversing “pre-announcement losses, with the long-end rallying given the FOMC’s heightened rate forecast for 2022-2023 and the negative economic effects that will result.”

As Treasury yields have made their way to new historic highs this week, “munis have worked hard to outperform the sell-off, particularly on the short-end,” Lipton said.

Helping muni outperformance is the lighter the new-issue calendar, he said.

While he expects issuance to “pick up this month as monetary policy anxiety dissipates somewhat, the scheduled FOMC meetings for November and December will likely influence Q4 supply to the downside.”

The long-end of the muni curve, he said, “would need to rally significantly in the final quarter for issuance to demonstrate significant growth and any meaningful advances in refunding activity would require a material curve flattening bias.”

“While we are still having a difficult time getting our arms around the double-digit losses for [year-to-date] muni returns, the asset class is still less ‘red’ than the negative total returns on both UST and corporate bonds,” he said.

With the Fed rate hike, it should “lead to an initially higher rate on short-term muni money market funds,” said Cooper Howard, a fixed income strategist focused on munis at Charles Schwab.

In the past four instances when the Fed hiked rates, “the SIFMA muni swap index initially increased and then steadily fell,” he said.

Therefore, it wouldn’t be surprising “if a similar pattern emerged with the Fed hikes rates this week.”

“Muni money market funds have also been one of the only types of muni funds that have attracted flows this year,” Howard said. “Positive flows for short-term munis has led to lower yields relative to Treasuries and a positively sloped muni curve.”

He continues to see “value in longer-term taxable munis relative to corporates.” The taxable muni index is down 16.6% year-to-date, the worst performance among the major indices that we track. However, yields for highly rated taxable munis look attractive still look attractive, he said.

The Investment Company Institute reported $1.671 billion of outflows from muni bond mutual funds in the week ending Sept. 14 compared to $2.034 billion of outflows the previous week.

Exchange-traded funds saw outflows of $51 million versus $130 million of inflows the week prior, per ICI data.

Secondary trading
Prior to the FOMC announcing its 75 basis point rate hike, Georgia 5s of 2023 were at 2.67%-2.65%. NYC 5s of 2024 at 2.82%. California 5s of 2024 at 2.76%. NY Dorm PIT 5s of 2025 at 2.86%-2.89%.

California 5s of 2029 at 2.89% versus 2.65% on 9/7. Minnesota 5s of 2030 at 2.89% versus 2.76% Monday. Washington 4s of 2031 at 3.23%.

Indiana Finance Authority 5s of 2033 at 3.51%-3.50% versus 3.21%-3.19% on 9/12. California State Department of Water Resources 5s of 2034 at 3.08% versus 3.08% Monday and 2.94% original on 9/13.

DC 5s of 2047 at 4.01% versus 3.92%-3.94% Friday and 3.76% on 9/8. Triborough Bridge and Tunnel Authority 5s of 2047 at 4.37%-4.35% versus 4.35%-4.37% Tuesday 4.29%-4.28% Friday. LA DWP 5s of 2052 at 4.05%-4.10% versus 4.08% Monday.

After the announcement, Maryland State Department of Transportation 5s of 2025 were at 2.74%-2.76% versus 2.66% Monday. Iowa Finance Authority 5s of 2027 were at 2.48%-2.43%.

Out long, Massachusetts 5s of 2049 at 4.11%-4.10%

AAA scales
Refinitiv MMD’s scale was unchanged 3 p.m. read: the one-year at 2.59% and 2.64% in two years. The five-year at 2.73%, the 10-year at 3.00% and the 30-year at 3.69%.

The ICE AAA yield curve was cut up to two to four basis points 10 years and in: 2.63% (+4) in 2023 and 2.69% (+4) in 2024. The five-year at 2.75% (+3), the 10-year was at 3.08% (+2) and the 30-year yield was at 3.67% (-1) at a 4 p.m. read.

The IHS Markit municipal curve was unchanged: 2.56% in 2023 and 2.62% in 2024. The five-year was at 2.72%, the 10-year was at 3.00% and the 30-year yield was at 3.71% at a 4 p.m. read.

Bloomberg BVAL was up to one basis points: 2.60% (unch) in 2023 and 2.63% (+1) in 2024. The five-year at 2.67% (unch), the 10-year at 2.96% (+1) and the 30-year at 3.70% (+1) at 4 p.m.

Treasuries were mixed.

The two-year UST was yielding 4.024% (+5), the three-year was at 3.978% (+4), the five-year at 3.745 (flat), the seven-year 3.655% (-3), the 10-year yielding 3.515% (-5), the 20-year at 3.744% (-9) and the 30-year Treasury was yielding 3.488% (-8) at the close.

FOMC hikes
With two meetings left this year to reach the 4.25% to 4.5% target, the FOMC would have to raise rates 75 basis points at one meeting and 50 at the other, assuming a full point hike won’t be coming.

Projections for 2024 are quite divergent, with the plurality of members expecting a 3.875% rate. Long-term a 2.5% target is expected.

Members expect GDP to rise only 0.2% this year and 1.2% next year, down from June’s predictions of 1.7% each year, while the panel lifted the expectations for unemployment to 3.8% this year and 4.4% next year.

Inflation, measured by personal consumption expenditures are seen dropping each year, but not at 2% until 2025, while the core falls to 2.1% that year.

“The turmoil in equities has been driven less by fear of 75 bps today but by realization that the Fed’s determination to bring inflation down — at whatever the cost — has hardened,” said Jan Szilagyi, co-founder and CEO of Toggle AI. “They have a brief window to act aggressively, and they seem eager to use it.”

Concentrating on the rate hike “totally misses what’s most important,” said Morning Consult Chief Economist John Leer. “FOMC members significantly increased their projections for inflation, unemployment and interest rates over the next two years and lowered their GDP growth forecasts. Even the Fed is growing less confident in its ability to achieve a soft landing.”

But Morgan Stanley economists contend, “The projections signal that the committee still believes that it can engineer a sizable increase in the unemployment rate without a recession.”

In his press conference, Federal Reserve Board Chair Jerome Powell noted the panel sees inflation risks tilted to the upside. The Fed is committed to bringing rates to restrictive levels and holding them there until the panel is certain inflation will drop to its 2% target.

When asked, Powell refused to say a 75-basis-point hike was the base case for the next meeting, saying it wasn’t discussed and won’t be decided until the meeting, and noted that many participants expect the target to rise 100 basis points, instead of 125 basis points by yearend.

While he expects below-trend growth, Powell wouldn’t address questions about recession. He said to get inflation down, slower growth and higher unemployment is necessary. He wouldn’t address the “hypothetical” question of how the Fed would know, given lags in monetary policy, if it had raised rates too much.

D.A. Davidson’s Ragan noted the statement confirmed “the Fed is more concerned about inflation than an economic slowdown.”

His takeaway from the Summary of Economic projections is a terminal rate of 4.6%, up 80 basis points from the previous expectation. “This is very much in-line, we believe, with market expectations that have assumed more hiking from the Fed this year and a higher terminal rate,” Ragan said.

And while rates are likely now restrictive, he added, “Powell has said that economic data, particularly employment data, is needed to confirm that.”

“While the near-term hawkishness was more than probably anyone had expected with an upper-bound policy rate of 4.50% projected by the end of this year, and up to a peak of 4.75% early next year, the ‘higher-for-longer’ narrative that policymakers have tried to push in recent weeks somewhat crumbled as the Fed has penciled in more rate cuts in 2024 and 2025 than perhaps anyone had expected, with rates seen back below 3% by the end of 2025,” noted Tom Garretson, senior portfolio strategist at RBC Wealth Management.

Markets, he said, seemed more focused on the possibility of 4.75%, “which is deeply into restrictive territory, in our view, as risk assets have sold off and as Treasury yields at the long-end have moved sharply lower, driving even greater yield curve inversions.”

Further, Garretson said, the chances of a “hard landing” or “a policy error have only increased in the aftermath of this meeting.”

Fed GDP and unemployment projections for 2023 “remain too optimistic,” he said, and he expects an unemployment rate up to 4.9% with “barely positive” growth, “leading the Fed to deliver insurance rate cuts as early as the back-half of next year.”

Primary on Tuesday:
J.P. Morgan Securities priced for the San Diego Unified School District, California $500 million of green 2022 dedicated unlimited ad valorem property tax general obligation bonds. The first tranche, $2.990 million of Election of bonds (Aa2///), Series O-1, saw 3.95s of 10/2023 price at par, noncall.

The second tranche, $147.010 million of Election of 2012 bonds (Aa2//AAA/AAA/), Series O-2, saw 5s of 7/2024 at 2.63%, 5s of 2028 at 2.70%, 5s of 2030 at 2.81%, 4.25s of 2047 at 4.42% and 5s of 2047 at 4.05%, callable 7/1/2032

The third tranche, $345.025 million of Election of 2018 bonds (Aa2//AAA/AAA/), Series F-2, 5s of 7/2024 at 2.63%, 5s of 2028 at 2.70%, 5s of 2030 at 2.81%, 5s of 2037 at 3.57%, 5s of 2042 at 3.89% and 4.25s of 2052 at 4.48%, callable 7/1/2032

The fourth tranche, $4.975 million of Election of 2018 bonds (Aa2///), Series F-1, saw 3.95s of 10/2023 price at par, noncall.

Competitive:
The Board of Water Works of the Louisville/Jefferson County Metro Government, Kentucky, is set to sell $128.660 million of water system revenue and refunding revenue bonds, Series 2022, at 10 a.m. eastern Thursday.

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