Full Steam Ahead
March 15, 2023
Full Steam Ahead
March 15, 2023
Federal Reserve Board1
The Federal Open Market Committee (FOMC) voted unanimously to increase the federal funds target rate by 0.25% to a range of 4.50% to 4.75% at the conclusion of its February meeting. The statement was relatively unchanged from the prior month, but FOMC members noted that further rate hikes are necessary. The February FOMC meeting notes showed that “a few” participants preferred a 0.50% rate hike. The committee believes upside risks to inflation remain present. February economic data came in stronger than expected, shifting market forecasts to a fed funds terminal rate of around 5.4%.1
European Central Bank1
At the European Central Bank’s (ECB) policy meeting on February 2, President Lagarde and the policy committee increased the ECB deposit rate by 0.50% to 2.50%. The accompanying press release stated the ECB “intends” to continue raising the deposit rate by 0.50% at its next meeting. The Governing Council will reduce the size of the asset purchase program (APP) by €15 billion a month from March to June. The committee reiterated it will remain “data-dependent” moving forward when assessing the future path of policy rates.
Bank of England1
The Bank of England (BoE) Monetary Policy Committee (MPC) voted 7-2 to increase the Bank Rate by 0.50% to 4.00% at its February meeting. The two dissenting members preferred to keep the rate unchanged at 3.50%. The BoE noted that market expectations see the Bank Rate moving toward a terminal rate of 4.5% by mid-year. Considering consumer price index annual calculations, the MPC believes inflation will decline significantly from the 10.1% level in January as elevated energy and goods prices roll off. The central bank is keenly focused on upcoming inflation data, which will dictate the future path of the Bank Rate.
February reminded the market that the path to stable inflation is not a straight line and the process will likely remain choppy. Our view is that the Fed is still far from claiming victory—and, if anything, officials will need to reinforce the “higher for longer” theme at the March 22 FOMC meeting, as well as present a revised dot plot conveying this message. Pricing in the back half of February began to reflect this reality as financial conditions tightened again.
Auctions have been orderly, and long-dated auctions (1-year bill) have been very well subscribed. As six-month auctions find themselves maturing in August, money market funds generally have been more cautious about adding to these late-summer maturities. Relatively less risk-sensitive, yield seeking investors, however, have kept these auctions from being too erratic so far. Late-month macro volatility has brought a firm bid back to short-dated bills (those maturing inside of one month).
Federal Reserve policy remains paramount—the Fed downshifted to a 25-basis point hike on February 1, but data globally has reaccelerated since then. This resilience will test the Fed’s steadfastness in sticking with 25-basis point hikes moving forward.
Debt ceiling considerations have started to percolate through our market and will continue to do so as the year progresses. Currently, it is still early in the process with new information coming out each week. While liquidity remained ample with plentiful supply, it is likely to be volatile amid the debt ceiling negotiations. Reverse repo (RRP) balances remain high and there is capacity to extend if needed.
In this environment, there were no material changes to our investment thesis. The portfolios’ weighted average maturity (WAM) and weighted average life (WAL) remained close to peers and on the shorter end of the spectrum, as we expect more rate hikes to come.
February saw spreads continued to grind lower throughout the month and remain near recent tights. Against this backdrop, we allowed the portfolios to organically roll down with zero opportunity cost as majority of Fund investments mature near the March FOMC meeting. Overall, market liquidity remained stable in the month, with ample supply and unconstrained dealer balance sheets.
While spreads can widen rapidly during times of market stress, we currently don’t see any immediate macro catalyst pushing spreads wider. From an investment perspective, we need to remain patient and disciplined when spreads are tight and only deploy capital if we believe the investment is being compensated for both interest rate and credit risk.
Monetary policy remains the key driver of portfolio composition and positioning. We still think daily resetting floating-rate notes offer the most attractive opportunity because their coupons continue to reset higher as Fed tightens monetary policy, while also remaining at an elevated level once the Fed reaches the terminal rate. Floating-rate notes can also offer a buffer from interest rate risk as coupons continue to reset if the Fed tightens by more than the market anticipates.
Short-term municipals saw a significant spike in rates in February, recovering from the drop rates in January. The SIFMA Index,4 which measures yields for weekly variable rate demand obligations (VRDOs), rose 176 basis points to finish the month at 3.42%. The longer end of the municipal money market maturity range rose as well over the course of the month. The Bloomberg BVAL One-Year Note Index5 increased 83 basis points, finishing the month at 3.17%. As we head into tax season, we believe rates will likely rise as investors sell tax-exempt money funds to raise cash in order to meet tax payments.
Municipal credit quality continues to remain solid, and higher employment, increasing wages and rising property values have all served to bolster tax receipts. In general, municipal bonds as an asset class are also considered more defensive than most others during times of economic stress. State and local governments budget in advance, and it takes some time for economic downturns to start affecting their balance sheets— even more so for local municipalities that rely heavily on property taxes. Housing property tax receipts typically decline years after economic shocks, as it takes time for home values to be reassessed.
We continue to place an emphasis on maintaining high levels of liquidity with diligent oversight of credit quality, portfolio maturity and diversification. The WAM on the portfolio shortened in February as tax-exempt commercial paper rolled down. Overall, we believe the portfolio is well positioned for a rising rate environment, with a short duration and high concentrations in VRDOs and floating-rate securities.
One basis point = 0.01%
The Bloomberg U.S. Municipal Bond Index is an index that covers the USD-denominated long-term, tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds. It is composed of approximately 1,100 bonds.
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