Federal Reserve Board¹

The Federal Open Market Committee (FOMC) voted unanimously to keep the federal funds rate unchanged at a range of 0.00% to 0.25% at the conclusion of its December meeting. Of particular note, and in line with recent market expectations, the Federal Reserve (Fed) announced that it would accelerate the winding down of its asset purchase program, increasing the reduction from $15 billion to $30 billion a month. This puts the Fed on pace to conclude the program around March 2022.

The December meeting included an update of the Fed’s summary of economic projections. The 2022 “dot plot” now shows all 18 voting members believe a rate hike is appropriate in 2022, an increase from nine members in the September projection. The median expectation for the fed funds rate is 1.6% and 2.1% at the end of 2023 and 2024, respectively. The FOMC downgraded its 2021 real gross domestic product (GDP) forecast to 5.5% from 5.9% estimated in September. The downgrade in GDP can be attributed to rising COVID-19 case counts and supply chain bottlenecks. Additionally, the Committee increased its inflation projections to 5.3% for 2021, up from its September forecast of 4.2%, for personal consumption expenditures (PCE). 2022 PCE projections increased 40 basis points to 2.6%. In addition, the Fed estimates core PCE rising to 4.4% for 2021, higher than the 3.7% forecast in September, but ultimately leveling out marginally above 2% in the years following.

European Central Bank¹

At the European Central Bank’s (ECB) policy meeting on December 16, President Lagarde and the policy committee left the ECB deposit rate unchanged at -0.50%, as expected. The committee left the total size of the pandemic emergency purchase program (PEPP) and asset purchase program (APP) unchanged. However, the ECB noted it would reduce the pace of purchases under the PEPP in the first quarter. The release noted, “progress on economic recovery and towards its medium-term inflation target permits a step-by-step reduction in the pace of its asset purchases over the coming quarters.” Purchases under the PEPP will end in March 2022. Similarly, the Governing Council will reduce the size of purchases under the APP by €10 billion a quarter until October 2022 where purchases will level off at €20 billion a quarter for “as long as necessary to reinforce the accommodative impact of its policy rates.”

Bank of England¹

The Bank of England (BoE) Monetary Policy Committee (MPC) voted 8-1 to increase the Bank Rate 0.15% to 0.25% in response to elevated inflation. The MPC unanimously voted to leave the size of its U.K. government bond purchase program unchanged at the conclusion of its December 16 meeting. The committee was undeterred by the omicron variant, although noted it “poses downside risks in early 2022.” Policy will continue to focus on the medium term as policy decisions and inflation impacts tend to lag each other. Looking forward, the BoE will remain attentive to incoming data and expects “inflation to remain around 5% through the majority of the winter period, and to peak at around 6% in April 2022.”

PORTFOLIO STRATEGY

PRIME STRATEGY³

On the month we purchased both fixed- and floating-rate securities, with fixed tenors in the first half of 2022 and floating-rate securities with maturities in the second half of 2022, that reset off of the SOFR index with coupons that will immediately reprice in the event the Fed hikes rates. Our portfolios ended the month with WAMs (weighted average maturity) on the lower end of the peer group and with weekly liquidity on the higher end of the peer group near 60%.

GOVERNMENT/TREASURY STRATEGY⁴

At quarter-end, the volume in the reverse repurchase agreement (RRP) facility hit a new high of approximately $1.904 trillion4 across 103 counterparties, highlighting the supply scarcity at year-end and dealer balance sheet constraints. Short-dated Treasuries rallied heading into the last week of the year as investor demand overtook attractive investment options overall. We took this opportunity to sell select Treasuries and agencies at attractive bids, reinvesting most of the proceeds into either overnight repurchase agreements or Treasury bill auctions. Just before their holiday recess, Washington legislators agreed to a procedural path to resolve the debt ceiling. The debt limit was increased by $2.5 trillion and pushed off another debt ceiling episode until after the midterm elections. This allowed the U.S. Treasury to increase supply heading into year-end, which moved auction stop-out yields slightly higher on supply. Market expectations continued to rise in anticipation of multiple rate hikes in 2022 by the FOMC and on their action to speed up and end asset purchases in March 2022. Portfolio durations fell during December as we sold positions mentioned and structured the portfolios for expected rate hike action in 2022. We continued to manage the portfolios to be responsive to changes in market conditions and interest rate levels.

TAX-EXEMPT STRATEGY³

At the short end of the curve, yields for variable rate demand obligations (VRDOs) rose steadily during the month of December. The SIFMA Index,⁵ which measures yields for weekly VRDOs, rose from 0.05% at the beginning of the month to finish the month at 0.10%. Yields at the longer end of the municipal money market maturity range were largely unchanged over the course of the month. The Bloomberg BVAL One-Year Note Index⁶ finished the month at 0.17%.

December municipal bond issuance was up nearly 10% year-over-year at $38.2 billion,⁷ but total volume in 2021 fell just shy of last year’s record. The municipal market saw $475.3 billion of debt issued in 2021, down 1.9% from $484.6 billion in 2020.7 While supply did not meet some market participants’ expectations, many in the industry still consider the figure a remarkable feat for state and local governments as the COVID-19 pandemic continued to disrupt economies, supply chains, health care systems, the travel and entertainment industries, and life around the world for a second year.

¹ Source: Bloomberg.

² Weighted Average Maturity (WAM): Measures the weighted average of the maturities of the portfolio’s individual holdings, taking into account reset dates for floating rate securities.

³ The Portfolio will be required to price and transact in their shares at a floating net asset value (“NAV”) and will be permitted to impose a liquidity fee on redemptions or temporarily restrict redemptions in the event that the Portfolio’s weekly liquid assets fall below certain thresholds.

⁴ Source: Federal Reserve. As of December 31, 2021.

⁵ The SIFMA Municipal Swap index is a 7-day high-grade market index comprised of tax-exempt VRDOs reset rates that are reported to the Municipal Securities Rule Making Board’s (MSRB’s) SHORT reporting system.

⁶ The Bloomberg BVAL One-Year Note Index represents tax-exempt municipal bonds that have an average rating of AAA by Moody’s and S&P. “Bloomberg®” and the Bloomberg Index/Indices used are service marks of Bloomberg Finance L.P. and its affiliates, and have been licensed for use for certain purposes by Morgan Stanley Investment Management (MSIM). Bloomberg is not affiliated with MSIM, does not approve, endorse, review, or recommend any product, and does not guarantee the timeliness, accurateness, or completeness of any data or information relating to any product.

⁷ Source: Bloomberg. As of December 31, 2021.

The views and opinions expressed are those of the Portfolio Management team as of December 31, 2021 and are subject to change based on market, economic and other conditions. Past performance is not indicative of future results.