Bond market participants appear to be reassessing the odds of a Fed rate cut on 2019. A rate cut became the consensus last quarter when Chair Powell shifted to a “patient” stance and global economic indicators turned softer. Talk of a 2020 recession in the U.S. was abetted by a modest inversion of the Treasury curve. That optimism on rates fostered a 3% first quarter return for the aggregate market index, a 2.9% return for the muni index and a 7.4% return for the high yield index.
Last week, however, the economic data were clearly not consistent with recession fears. The two ISM indices were at solid growth levels and the new orders components were strong. Sales of new cars and light trucks stayed above the 17 million annual rate in March. Payroll employment was better than expected and unemployment stayed low, whether measured by initial claims or by the unemployment rate. Thus, the fed funds futures markets no longer expects a rate cut this year.
Is, therefore, a rate increase a possibility? A few sets of data cited by Randy Forsyth in Barron’s are interesting in that regard. Since Powell restated the policy outlook in January, commodity prices have increased at an 85% annual rate, global equity prices are up at a 68% annual rate and financial conditions, as measured by the Chicago Fed, are the easiest since 1994. Finally, refi activity is again surging. Does this sound like an economy that needs lower rates?
The U.S. economy never grows at a steady pace, even in a sustained expansion. There are always a quarter or two of slower GDP growth after several quarters of relatively rapid growth. Indeed, the slower growth is welcome because it helps extend the expansion. Today, with the economy at full employment, if GDP growth were to stay at 3% or better each quarter, a recession in 2020 would probably be more likely, not less likely. Inflation would probably become more threatening and the Fed would probably need to abandon its “patient” policy stance.
If optimism about rate cuts got overdone last quarter, it follows that bonds got overbought. Barron’s also quotes several bond portfolio mangers who are extending to longer maturities and weaker credits, including CCC corporates, in order to find yield. This should be a warning that investors should now be “patient”. Wait for better values.
Nowhere is patience warranted more than in the muni market. Municipal-to-taxable yield ratios have returned to pre-crisis ranges. The nice relative values of the past 10 years have been eroded by a combination of strong demand and limited net issuance. But, the low yields are changing the supply outlook, especially for weaker names. Those authorities have ramped up borrowing programs. They would be irresponsible if they didn’t take advantage of this buying frenzy. As this process proceeds, the weaker credits will account for a larger share of the tax-exempt market indices. Thus, investors might want to think twice before purchasing a muni index fund. Sound credit research is likely to prove very valuable in the months ahead, as will conservative duration strategies.