By John R. Mousseau, CFA
Another bad quarter for the good ones: some of the usual suspects to blame, but there are some hopes ahead.
The second quarter of 2022 was another brutal one for fixed income instruments, with yields increase across the board.
The story was even worse for the tax-free munis. Below are the AAA tax-free returns and their yield ratios to Treasury bonds.
Let’s gather the usual suspects.
The Federal Reserve
The Fed began raising short-term interest rates in response to stubborn inflation figures from March. In our view, this rise in the federal funds target rate should have started last summer, when we had already begun to see the rate of inflation rise after the pandemic.
The Fed is in the STRONGest upward movement of the federal funds target rate since 1994, as shown in this chart. Fed hiking, along with its stronger rhetoric, has scared all bond markets from March through the second quarter. This month’s 75-point hike is expected to meet another next month. At the same time, the Fed has put an end to its quantitative easing. (Again, in our opinion, this ended about six months before it should have.) Of course, the rise in short-term rates is felt throughout the economy, from the adjustable rate loans up to credit card financing rates and the mortgage market.
Settlement of bond funds
As the chart below shows, bond fund settlements have been severe. With the exception of the strong sale caused by COVID (followed by a rapid rise), the settlements have been the worst in recent history. Bond fund settlements tend to feed on their own and are often fueled by significant inflows that precede outflows (as seen in 2021). We have recently started to see that outflows are slowing down (they become less negative). All muni bond fund sales in the “Muni Party and Hunger” chart below have the common denominator of fund outflows.
There is no doubt that inflation and inflation expectations have also scared bond markets.
Both the CPI and the CORE CPI are at high levels. The Federal Reserve withdrew its “transitional” characterization of inflation a few months ago, and that change has gone hand in hand with the rising rate of short-term rate hikes.
There is light at the end of the tunnel? We think so.
Although inflation is high, the inflation expectation derived from the bond market through equilibrium rates is much lower. The graph below shows the 10-year equilibrium inflation rate.
But the market inflation expectation is much closer to the long-term inflation rate. The equilibrium rate of inflation, derived from the difference in yields between the actual yield on a 10-year Treasury inflation index (TIP) bond and the nominal yield on a 10-year U.S. Treasury bond it stands at around 2.6%; and while this is much higher than during COVID, it is only marginally higher than a year ago. In other words, markets believe the Fed should be reasonably successful in fighting inflation in the future. While this indicator is not necessarily a better predictor of inflation than other measures, it is derived from the market. This is a testament to the Fed’s success over the past 40 years in lowering long-term inflation expectations.
Commodity prices have begun to soften.
Inflation itself is a lagging indicator, an indicator that can stay in one trend while the economy has turned in another trend. In addition to wood, copper, and commodities in general, things like shipping rates have also started to go down. In other words, inflation may have peaked, although it is clear that food and fuel prices have been driven by the war in Ukraine.
Bond yields are now much higher than they used to be. Tax-free municipal bonds are very cheap, in our opinion, with returns in excess of 4% that offer equivalent taxable returns ranging from 6.3% to over 8%, depending on state taxes and exemption. Undoubtedly, this is a different environment than we had been since the summer of 2020. And it is important to remember that these higher nominal coupon levels, when reinvested, can make a huge contribution to the long-term profitability of portfolios. good. This is not to discount the damage the bond market has suffered. But we believe that, from these levels, the links are more attractive than they have been for a long time.
Our claim is that the fall in the muni market was not caused so much by the level of interest rates (in fact, 10- and 30-year Treasury bonds are at the yield levels where they were at the end of 2018). Rather, it is the rapidity of rising rates that scared investors from bond funds.
So as we begin the third quarter of the year, we believe we will see some reversal in the average yield on bonds, especially with tax-free bonds. This expectation is supported by the fall in raw material prices and the fall in housing starts, sales of both existing and new homes, retail sales, etc. begin to moderate – with the help of the usual suspects.
Editor’s note: The summary peaks in this article were chosen by the editors of Seeking Alpha.