In technical terms, it was purely and simply a “wimp-out.” After leading global financial markets into the red zone, the Fed shockingly chose to punt (okay, shaky football analogy, but you get the point). Going into Wednesday’s FOMC meeting, Fed officials must have been aware that a mini-taper effort in the $10-15 billion range was already built into the market consensus. They decided instead to do nothing and maintain the QE program at current levels.
There was some logic behind the madness, of course. Recent economic data, particularly on the jobs front, have painted a weaker economic picture than earlier in the summer. Of equal importance, in our view, the Fed’s forward guidance seems to point toward a softer economy for the rest of the year. One has to believe that Fed officials also got spooked by the increasingly contentious tone of the debt ceiling debate in recent days and the potential fiscal drag from another protracted budget debate. In the end, they chose to play it safe and await further confirmation that the economy can finally stand on its own without ongoing monetary stimulus.
Could this be the beginning of the turn in fund flows?
Needless to say, both the equity and fixed-income markets welcomed this reprieve. Stock indices hit new record highs before fading back a bit. The Treasury market went into a powerful steepening rally, with the yield on the 10-year note dropping by 16 basis points on the week to 2.75%, compared to a mere six basis point move for the 30-year bond. At least for the time being, the specter of a 3.00% 10-year Treasury does appear a bit more remote.
In the end, this week’s FOMC decision only delays the inevitable. The market will now go back to fretting about the debt ceiling, another potential government shutdown and of course, the next employment number. As the Wall Street Journal points out this morning, the last minute flip-flop might end up undermining the Fed’s future credibility as it tries to communicate its intentions to the markets. But, as outgoing Chairman Bernanke must be thinking, let that be Janet Yellen’s problem.
Although the tone in the municipal market has been firming over the past week, the FOMC’s decision has unleashed a powerful rally which saw tax-exempt yield levels gapping down by as much as 30-40 basis points for certain names. As of Thursday night, the Municipal Market Data (MMD) curve has downshifted by 26 basis points in the 10-year range and by 19 basis points in the 30-year maturities, as compared to last Friday’s closing levels. In fact, this marks the first time in weeks that municipals have outperformed Treasuries in a rally.
This week’s explosive rally occurred in spite of continuing mutual fund outflows, although the bulk of those fund redemptions may have occurred earlier in the week, before the FOMC announcement. Muni bond funds that report weekly recorded outflows of $1.10 billion for the week ended September 18, according to Lipper, an improvement from last week’s $1.90 billion in redemptions. Long-term funds recorded outflows for a 29th consecutive week, at $473 million, compared to $1.04 billion for the week of September 11. Interestingly, flows into high yield funds turned positive again, to the tune of $181 million, reversing the $168 million in outflows from last week. Could this be the beginning of the turn in fund flows? We’ll find out next week, after retail investors have had a chance to digest and react to the news.
… we would still urge caution at this time, as the market may have come too far too fast.
So where do we go from here? As we pointed out in last Friday’s column, we believe this summer’s relentless sell-off has turned the municipal market into one of the best relative values among all fixed-income asset classes, with or without Fed tapering. Based on this week’s positive action, many market participants seem to be in agreement with us.
Having said that, we would still urge caution at this time, as the market may have come too far too fast. Current tax-exempt levels have yet to be tested by real supply. This week’s new issue volume was well-below normal and it’s only a matter of time before all the deals sidelined by unfavorable market conditions reappear on the forward calendar.
We would also remind you to maintain a focus on credit and relative value and not get too caught up in chasing the market. In other words, there’s no reason to pay up for troubled names such as Puerto Rico just because the market is up, unless you perceive there has been a fundamental change in the credit outlook.
Beware also of marginal health care names: Republicans are tying the current debt ceiling debate to funding for the Affordable Care Act (ACA). The market is currently penalizing lower-rated health care issuers in States that have opted out of Medicaid expansion. Any change in the timing of implementation of the ACA may impact the outlook for such issuers (We’ll discuss the health care sector outlook in more details in next week’s column).
Speaking of relative value across global asset classes, the Republic of Colombia (rated Baa3 by Moody’s) priced a $1.6 billion 10-year note issue yesterday at +142 over 10-year Treasuries (“T10”). The City of Chicago’s taxable G.O.s in the 10-year range is currently quoted around +330 versus T10. Now, Chicago is officially rated A3/AA-/AA-, although nobody really believes those ratings, and it certainly has a serious pension funding problem, but should it trade at more than twice the spread of an emerging market issuer? In fact, Chicago’s current trading level is closer to that of the Republic of Armenia, a “BB minus” rated issuer that also accessed the capital markets yesterday.
Food for thought, isn’t it?
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