Federal Reserve Board

The Federal Open Market Committee (FOMC) voted unanimously to increase the federal funds target rate by 0.75% to a range of 3.00% to 3.25% at the conclusion of its September meeting – the third consecutive meeting with such a large interest rate increase. Much of the press release was unchanged from the prior meeting, as the committee continues to observe a strong labor market, low unemployment and persistent inflation. Committee members remain “highly attentive” to incoming inflation data and the surrounding risks (including geopolitical risks, oil/energy prices and others).

The September meeting included an update of the Federal Reserve’s (Fed) summary of economic projections. The Fed’s dot plot showed officials’ median projection for the benchmark rate at the end of 2022 is approximately 4.4%, up 100 basis points since June. The 2022 median gross domestic product (GDP) growth projection was downgraded 150 basis points to 0.2%. The 2023 and 2024 GDP growth forecasts were downgraded as well, to 1.2% and 1.7%, respectively. The 2022 and 2023 unemployment rate estimates were increased 10 and 50 basis points, respectively. The Fed increased its median 2022 personal consumption expenditure (PCE) inflation forecast to 5.4% in September, from 5.2% in June. The 2023 PCE forecast was increased to 2.8% from 2.6%. 

While the FOMC downgraded its view of the economy as a whole in September, the committee would likely welcome this type of outcome. Chairman Powell is adamant about reducing wage inflation pressures, as he views this as one potential way to materially reduce inflation. On the downside, however, the updated projections suggest inflation likely won’t be arriving at the Fed’s “around 2%” target until late 2024 or 2025.

European Central Bank 

At the European Central Bank’s (ECB) policy meeting on September 8, 2022, President Lagarde and the policy committee increased the ECB deposit rate by 0.75% to 0.75%. The Governing Council was clear in its forward guidance, stating it “expects to raise interest rates further.” September inflation data came in above expectations, hitting 10%, and likely pushing the ECB’s hand further. The labor market has remained somewhat resilient, however. As inflation becomes more entrenched the committee is likely to focus more heavily on extinguishing the inflation fire.   

Bank of England

At its September meeting, the Bank of England (BoE) Monetary Policy Committee (MPC) voted 5-4 to increase the Bank Rate by 0.50% to 2.25% in response to elevated inflation. Three of the dissenting votes preferred a 0.75% increase and one dissenting vote preferred a 0.25% increase. The MPC noted that the sterling has depreciated significantly since August as global bond yields have risen. Amid the sharp increase in longer-dated bond yields, the BoE took historic action in September, announcing it would start buying long-dated U.K. government bonds. Concerned about financial stability, the committee believes this operation will help “restore orderly market conditions.” These purchases will last for two weeks and are only aimed at long-dated government bonds. Additionally, the committee announced it would be postponing its £80 billion stock reduction to October 31.

PORTFOLIO STRATEGY

Prime Strategy

As of September month-end, the market is pricing in another 75 basis point rate hike at the upcoming November FOMC meeting and another 50 basis point increase in December. With expectations that the Fed will continue to tighten monetary policy in the near term, we remain comfortable managing the portfolios with elevated levels of liquidity and a short duration profile. Allocations to daily resetting SOFR (secured overnight financing rate) and OBFR (overnight bank fund rate) floating-rate notes continue to benefit the portfolios as their coupons reprice immediately following each rate hike and help meet our objectives of capital preservation and liquidity.

Government/Treasury Strategy

September was a volatile month in bond markets, especially after Chairman Powell’s late-August Jackson Hole speech reaffirmed the Fed’s desire to stem inflation. FOMC communications throughout September reflected a steadfast approach, and this theme was further exacerbated by a higher-than-expected consumer price index (CPI) report mid-month. Domestic and global markets priced in more central bank action, and the Fed delivered another 75 basis point hike in September. While expectations were hawkish heading into the meeting, the Fed’s outlook and dot plot acknowledged a still-higher terminal rate, fueling a repricing in bonds. Within our portfolios, we have continued to favor a conservative posture on WAM (weighted average maturity), as rates continue to sell off and a variety of investor types favor the very short end of the money market curve. Looking into October, the payrolls report and CPI print will be crucial to earmark whether the Fed is making progress on its inflation objective thus far.

Tax-Exempt Strategy

The front end of the AAA tax-exempt municipal yield curve saw significant upward pressure in September. At the short end of the municipal curve, yields for variable rate demand obligations (VRDOs) rose during the month, driven higher by Fed rate expectations. The SIFMA Index, which measures yields for weekly VRDOs, increased 96 basis points to finish the month at 2.46%. The longer end of the municipal money market maturity range rose over the course of the month as well. The Bloomberg BVAL One-Year Note Index increased 76 basis points, finishing the month at 3.04%. Our portfolio is well positioned for a rising rate environment, being short duration with high concentrations in VRDOs.

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 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.

⁵ 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.

The views and opinions expressed are those of the Portfolio Management team as of September 30, 2022 and are subject to change based on market, economic and other conditions. Past performance is not indicative of future results.