Fed Chair Powell’s first of two days on Capitol Hill went mostly as expected. He characterized the economy as “in a very good place,” but also noted that some impact from the spreading coronavirus on the economy is inevitable. He did say the Fed is watching the virus’ impact to judge if it becomes persistent and material. Venturing an opinion, we think the virus will become persistent and material and as such will continue to provide a safe haven bid to Treasuries for some time to come. In fact, markets are quickly moving past the mostly upbeat round of economic releases (jobs report, ISMs, etc.), and attempting to price the effects of the virus on various industries and countries. That’s not to say investors will ignore the January CPI report tomorrow and retail sales on Friday, but the response will most likely be skewed. That is, if the two reports are strong—normally implying higher yields— that response will be muted as it happened “before the virus.” That leaves us seeing a new range for the 10-year Treasury in the near-term with 1.68%-1.75% as a top while the 2019 low yield of 1.46% represents a target for a continued rally.
Fed Chair Powell spent yesterday testifying in front of the House Financial Services Committee and will spend today in front of the Senate Banking Committee. Some of the high points from yesterday’s testimony and questions are summarized below.
- Powell characterized the economy as “in a good place” with the one big exception being the potential impact from the spreading coronavirus.
- Powell said the Fed is watching the virus’ impact to judge if it becomes persistent and material, but at this time it’s too early to hazard a guess as to its impact. We tend to think the virus will become persistent and material and will continue to weigh on the global growth outlook and provide an ongoing safe haven bid to Treasuries.
- Our rationale for that takes us back to the experience at Chernobyl. The initial reaction of the Soviet regime was to deny and downplay the seriousness of the accident that eventually became too big for their propaganda effort to contain. We think a similar scenario is playing out now. Most likely the Chinese government, in its authoritarian instincts, is under-reporting infection data, perhaps massively, in the pandemic regions of Hubei and Zhejiang provinces in order to craft a hopeful narrative. You don’t scramble to build hospitals in a week just out of an abundance of caution. It’s also likely the Chinese epidemic-fighting policy is being driven more by meeting this hopeful narrative to find and count the “right number” of coronavirus casualties. Thus, we think the true impact will get worse. The good news so far, if you can call it that, is the lethality is on the order of 1% to 2% of those infected which is much less than other pandemics. The economic impact, however, from plant closures, to travel restrictions, to quarantines, etc., is likely just starting to play out.
- As to other specific risks the Fed is watching, Powell noted cyber-crime and also the increasing exposure from leveraged lending, but he noted too the banking system as a whole is stronger than it’s probably ever been. Also, he mentioned that the Fed’s efforts to increase reserves and prevent another spike in short-term rates like last September have largely been successful with reserves likely reaching an appropriate level by mid-year.
As Muni Securities Roll Down the Curve, Opportunities Arise
The latest coronavirus-inspired rally in Treasuries has also had an impact on the municipal market. While yields have fallen across the Treasury curve, it’s created opportunities to actively manage the tax-free municipal sector and take advantage of the rally, as well as reposition to maintain yields.
The graph below illustrates current tax equivalent yields along various maturities of the two sectors. The blue line is the tax equivalent municipal yield curve and the red line is the Treasury curve. Notice how the short-end of the muni curve trades closer, and eventually through Treasuries. This is because individual/retail buyers tend to congregate in that part of the curve and also have tax rates upwards of 35% versus the corporate rate of 21%. Given the SALT cap from tax reform, individual investors in higher tax states have moved into muni’s as one of the few remaining tax-advantaged investments.
We can use this behavior to our advantage. As your muni bonds roll down the curve they are most likely accumulating sizeable unrealized gains given the attractiveness of those shorter maturities to the individual buyer. At CenterState, we actively look to sell those bonds once they move inside 8 to 10 years, take the gain, and redeploy further out the curve where yield spreads to Treasuries are more attractive as shown below.
If your portfolio has tax-free municipals with maturities inside 8-10 years, a similar swap could be beneficial. Your CenterState representative can run an analysis and determine if a muni swap could enhance earnings while maintaining yields.
Agency Indications — FNMA / FHLMC Callable Rates
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