April 28, 2023
Powell Doesn’t Flinch as Banks Collapse
April 28, 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 4.75% to 5.00% at the conclusion of its March meeting. During the month, several high-profile regional banks came under significant pressure to meet withdrawals. The Federal Reserve (Fed) and U.S. Treasury acted swiftly, securing uninsured deposits and preventing widespread contagion by announcing a newly created Bank Term Funding Program. The new facility made additional funding available to ensure banks have the ability to meet the needs of their depositors. On the back of this announcement, the FOMC press release noted that the U.S. banking system is “sound and resilient,” but these stresses are likely to result in tighter financial conditions and impact economic activity. The March meeting included an update of the Fed’s summary of economic projections. The Fed’s dot plot showed officials’ median projection for the benchmark rate at the end of 2023 is approximately 5.1%. The 2023 median gross domestic product (GDP) growth projection was downgraded 10 basis points to 0.4%. The 2024 GDP growth forecast was downgraded as well to 1.2%. The 2023 unemployment rate estimate decreased 10 basis points to 4.5%. The Fed increased its median 2023 personal consumption expenditure (PCE) inflation forecast to 3.3% in March, from 3.1% in December. The 2024 PCE projection was unchanged at 2.5%.
European Central Bank1 At the European Central Bank’s (ECB) policy meeting on March 16, President Lagarde and the policy committee increased the ECB deposit rate by 0.50% to 3.00%. The ECB updated its economic projections and now see inflation ending the year at 5.3%, then trending lower to 2.9% at the end of 2024. The committee has upgraded its projections for growth, which now sits at 1.0% for 2023 and moves upward toward 1.6% at the end of 2024. The committee remains dedicated to reducing inflation back to the 2% target and reiterated its “data-dependent” stance moving forward.
Bank of England1 The Bank of England (BoE) Monetary Policy Committee (MPC) voted 7-2 to increase the Bank Rate by 0.25% to 4.25% at its March meeting. The two dissenting members preferred to keep the rate unchanged at 4.00%. MPC members believe inflation is likely to decline more in the second quarter of 2023 than anticipated in February. The press release noted that GDP broadly has been flat to start 2023 but is expected to increase “slightly” in the second quarter. Reaffirming its stance from the prior month’s meeting, the BoE is monitoring economic conditions and adjusting policy as needed as it focuses on bringing down inflation.
We took advantage of the mid-month spike in volatility to add some callable agency debt across our portfolios, extending duration along with our peers into the mid-teens. To offset some of this extension, we also used the abrupt rally in interest rates to exit some legacy positioning in the portfolio.
The Federal Reserve expressed comfort with the handling of the Silicon Valley Bank (SVB)-led banking crisis in March, and toward the end of the month began to reiterate that the fight against inflation is not over. We expect the Fed to be nearing the end of its rate hiking cycle, but likely unwilling to change stance until officials see tangible evidence in either the jobs market or the inflation data. This likely argues for one or two more rate hikes followed by an extended period where rates remain at elevated levels and the lagged effects of recent tightening take hold.
Overall, we have no concerns with liquidity in the Treasury bill market currently. T-bill issuance sizes will likely begin to decrease as tax receipts come in and debt ceiling considerations come into play. Additionally, Treasury auctions have been orderly, and the SVB banking crisis in mid-March brought an onslaught of supply from the Federal Home Loan Bank system. Ample cash in the system was able to opportunistically scoop up this supply, and following that massive front-loading of issuance, agency supply has since quieted down. The U.S. Treasury has continued to use cash-management bills periodically to meet funding needs as they arise.
Looking ahead, we believe debt ceiling considerations will continue to grow in relevance as we approach summer. Currently, the late-July and early-August portion of the bill curve is reflecting concern about the “X-date,” the day when the U.S. government may no longer be able to meet all of its debt obligations.
In March, spreads widened intra-month as liquidity became scarce and investors stayed on the sidelines amid the banking sector turmoil. We remain cautiously optimistic that liquidity will continue to normalize as investors deploy excess cash and issuers return to the market following quarter-end.
The portfolios’ WAM and WAL decreased month-over-month as we increased our liquidity profile due to volatility in the financial sector. While spreads widened across the curve in the second half of the month, we felt it was more prudent to hold elevated levels of liquidity as opposed to taking advantage of market opportunities.
As we approach the likely end to this monetary tightening cycle, we find value in both fixed- and floating-rate securities across the money market curve. Spreads remain wide, and if the updated Fed dot plots look to be accurate—potentially hiking one more time and then holding rates constant throughout the rest of the year—then extending both duration and spread duration offers attractive opportunities right now. For longer-dated maturities we continue to prefer floating-rate securities as we believe they offer a measure of downside mitigation in the event the Fed tightens more than anticipated by the market.
In March, short-term municipal securities saw yet another significant spike in rates. The SIFMA Index,4 which measures yields for weekly variable rate demand obligations (VRDOs), rose 176 basis points to finish the month at 3.97%. Yields at the longer end of the municipal money market maturity range rose as well over the month. As sentiment regarding the stability of the financial sector continues to improve, short end rates have begun to tighten back. Going into tax season, we believe rates will likely remain elevated as investors sell tax-exempt money funds to raise cash in order to meet tax payments.
The WAM on the portfolio shortened in March as tax-exempt commercial paper rolled down and we looked to raise liquidity in stressed market conditions. 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.
Uncertainty around the Federal Reserve, the stability of the financial sector and the geopolitical landscape will likely continue to weigh on the market. Municipal yield movements are closely tracking the Treasury market’s high volatility, and it will likely require a calming of that volatility, as well as a more favorable technical municipal backdrop, to reignite persistent market conviction and sustained outperformance.
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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