“TMI!” … That’s what my children used to say in horror whenever I overstepped my parental bounds and “over-shared” information that they either didn’t want to hear or didn’t care about. Listening to Ben Bernanke speak to the media following the FOMC meeting, I was tempted to yell out the same thing: “too much information!”
By now, it’s clear the Fed’s efforts to communicate policy nuances to the market have backfired in a major way. In trying to explain the complexities of monetary policy, Chairman Bernanke has succeeded only in creating more fear and confusion. Forget the message of moderation that he was trying to convey. Forget the great vote of confidence he gave the U.S. economy, for its resiliency in the face of all the fiscal headwinds. Forget the very subtle difference between policy “triggers” and policy “thresholds.” Traders around the world only heard two things on Wednesday: first, “tapering” could start as early as this year, and second, somehow the Fed’s unemployment target has moved up from 6.5% to 7.0%. That was all they needed to run for the exits. With both bonds and equities selling off dramatically, there weren’t many safe places for investors to hide this week.
From here on, failure to do your homework on the creditworthiness of your muni holdings may result in actual losses, not just relative underperformance.
Is it possible the markets can’t make a distinction between a reduction in monetary stimulus and an outright tightening? We suspect that, while those two events are clearly distinct from each other, the market perceives them as being inextricably linked. In other words, once “tapering” begins, the move toward tighter monetary policy will be all but inevitable and probably irreversible for the balance of this cycle. The Fed believes it can fine-tune this process in response to incoming economic data but it may just be fooling itself. Once the genie’s out of the bottle, it will be near-impossible to convince him to go back in.
In any case, Mr. Bernanke may not be around to finish what he started. President Obama said as much during his European tour, and this may have struck another disquieting note in a market already on edge.
In our June 12th column, we looked for a re-test of last year’s highs in Treasury yields (2.39% and 3.48% on 10-year and 30-year bonds, respectively). We did get that yesterday, and then some. In fact, the government market has blown right through those presumed resistance levels. Thus, with 10-year Treasuries closing at 2.42%, a 13-month high on Thursday, traders will now have to assess how much technical damage was inflicted by this week’s market move.
The muni market also went into a free fall, with tax-exempt yields experiencing one of their largest one day moves in years: the long end of the Municipal Market Data benchmark curve was cut by a stunning 20 basis points, just on Thursday alone. A couple of the week’s major deals were pulled, including the $767 million St Joseph Health issue. The bellwether muni ETF, the iShares S&P National AMT-Free Municipal Bond Fund (ticker MUB) fell to a two-year low at $104.10.
The demand side of the market continues to be challenged by accelerating outflows from the mutual funds. According to Lipper, long-term weekly reporting muni funds reported even higher outflows this week, to the tune of $2.2 billion. For their part, high yield muni funds saw $850 million go out the door.
As we’ve pointed out before, this has been the first real test of muni liquidity in a down market since the financial crisis and the results have not been encouraging.
As usual, high grades have borne the brunt of the selloff, simply because they are the only things investors can even get a bid on. Lower-rated names appear to have held up better so far but that may just be a temporary illusion: holders of high yield paper are probably loath to test the bid side, if any, under current market conditions. Eventually, high yield prices will have to follow suit and be adjusted to reflect the new market levels.
If you’re brave enough to tiptoe back into the market at this stage, we believe you should stay with the best quality names you can buy at these higher yields. Aside from being your best relative values at this time, these issues will also snap back the fastest whenever the market regains its footing.
Thursday’s bloodbath, as one muni trader put it, did have the feel of a major short-term capitulation. Further weakness in the stock market should eventually prove supportive for bonds, so we’re cautiously optimistic that the current market pain will soon turn into a buying opportunity. After all, the bond redemption cash expected for July and August can be re-invested at much more attractive yield levels, especially now that potentially competing asset classes such as equities appear to be just as vulnerable as bonds.
As we’ve said many times before, the penalty for being wrong on credit has not been significant over the last two years, as a rising market has lifted all boats. This will no longer be the case as we enter a potentially more volatile phase of the cycle. From here on, failure to do your homework on the creditworthiness of your muni holdings may result in actual losses, not just relative underperformance. Of course, on the flip side, a strengthening economic environment should also be supportive of credit plays, as long as they are the correct ones.
Looking further ahead, we believe the speed and magnitude of this latest correction will accelerate the fixed-income markets’ gradual shift toward alternative trading models, in an attempt to broaden liquidity and lessen reliance on broker-dealer balance sheets. For instance, electronic matching platforms could evolve to put mid-market buyers and sellers, such as managers of Separately-Managed Accounts (SMAs) or independent registered advisors, in direct contact with each other. With the proper price discovery tools, muni investors may be able to reduce transaction costs while tapping into these new sources of liquidity. The broker-dealer community may not be quite supportive of these efforts initially, and quite understandably so, but we’re confident they will in the fullness of time find a way to be a part of this process. After all, a smoothly-functioning market should be in the best interest of all participants.
Having said that, we do realize the muni market is notorious for resisting any kind of change. We know the corporate market will get there first. When tax-exempts will follow suit is anybody’s guess.
Finally, we were looking for a way to pay homage to the late James Gandolfini of Sopranos fame. Although it was hard to find a quote from the show that is not laced with expletives, we did come up with one famous line from Tony Soprano: “Here comes the Prozac!” That’s a feeling that may be shared by many investors after this week.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
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