The one first-tier economic release this week is due tomorrow in the form of September CPI but we don’t think it will prove consequential to the Fed’s rate-cutting decision later this month. Rather, the ongoing dust-up over China trade and investment has increased market uncertainty. This morning there is some positive news that China is willing to increase purchases of ag and other products if the U.S. relents on tariff increases due next Tuesday and in December. The bigger picture items like IP theft and tech transfers would remain to be worked out later. The rumors of a limited deal have equity futures higher with a little yield give back in Treasuries. In the absence of a broader deal the Fed most likely views the latest developments as a reason to keep rate-cutting plans in place. In recent Fed speeches, including yesterday, Chair Powell has expressed the view that keeping the expansion rolling is Job 1 right now, and with the weak September ISM Surveys and so-so jobs report combined with the trade uncertainties, the aforementioned expansion is facing increasing headwinds. Thus, we don’t expect much push back from the Fed in regards to the 80% market odds of a rate cut on October 30 and indeed in a speech yesterday Chair Powell’s comments didn’t appreciably move those odds.
We came into the week thinking that Fed speak in regards to the increasing odds of a rate cut later this month would garner some headlines, and we also assumed some “good news” from the China trade negotiations might be in the offing to counter impeachment news. Well, we certainly didn’t get the China news right as the administration placed eight of the country’s technology giants on a blacklist over alleged human rights violations against Muslim minorities. The human rights angle is a new one for the administration as previous moves against Chinese companies like Huawei were based on national security grounds. If the rationale for expanding blacklists extends to human rights abuses it will open a wide avenue in which to operate.
Asked yesterday whether China would retaliate over the latest U.S. actions the foreign ministry told reporters “stay tuned” and the ministry also “urged the U.S. side to immediately correct its mistake, withdraw the relevant decision and stop interfering in China’s internal affairs. China will continue to take firm and forceful measures to resolutely safeguard national sovereignty, security and development interests.” That doesn’t sound like good news to us and markets took the heightened rhetoric to commence flight-to-safety trades that bolstered Treasury prices and sent stocks lower once again. The administration is also looking at ways to limit Federal pension plans from investing in mutual funds that track international indices which include Chinese companies. Both announcements came just as U.S./China negotiators are set to meet tomorrow in D.C. to resume trade talks. While the administration insists these are separate matters it’s not likely to sit that way with the Chinese officials.
In the meantime, in Chair Powell’s speech yesterday he mentioned the Fed will soon be releasing details about growing the balance sheet —mainly with Treasury Bill purchases— as one of the ways to add reserves to the banking system and alleviate stresses in the repo market that occurred last month. While his comments didn’t delve deeply into current policy he didn’t push back on the prevailing odds of a rate cut. After the weak ISM reports last week, and the middling jobs report, odds of a rate cut at the October 30 meeting rose to 80%. If the Fed is uncomfortable with that outlook this is the week to speak up. So far they haven’t. We think with the slowing in several economic indicators the Fed will err on the side of rate cuts, and that is likely even if we get a hot CPI report tomorrow. Powell has mentioned on numerous occasions that keeping the economic expansion on track is the Fed’s primary goal and thus we think inflation readings won’t stop a rate cut later this month.
Investment Recommendations — Non-BQ Municipals
As rates have moved lower over the past year, one of our ongoing investment recommendations has been longer-term municipal securities for their yield advantage and limited negative convexity allowing better roll-down-the-curve and total return performance in the lower-rate environment. Because muni supply this year has been limited, we’ve begun recommending non-bank qualified municipal securities. Sometimes, however, investors get hung-up on the BQ/non-BQ distinction. Essentially, BQ bonds are smaller issuers ($10mm/year max) and get a 20% TEFRA disallowance (Cost of Funds x 20% x 21% tax rate) which acts to reduce the tax equivalent yield. This yield reduction is currently around 2 to 3bps. Non-BQ bonds are issues from entities that sell in amounts far above the $10mm/year BQ limit. This larger issuance size, however, makes bonds more plentiful and often at attractive yields. The catch is that Non-BQ bonds have 5x the TEFRA disallowance (Cost of Funds x 100% x 21% tax rate). Thus, if BQ yield reduction is 2bps, non-BQ will be 10bps. However, with the 21% corporate tax rate and low cost of funds, the TEFRA disallowance calculation for non-BQ bonds is not overly punitive now, or for the foreseeable future. And the yield advantage of non-BQ bonds typically overcomes the larger TEFRA disallowance. Thus, we like non-BQ bonds as an investment and show a representative sampling below of the yield advantages of non-BQ bonds vs. BQ bonds (red boxed area). Our philosophy is to buy in the non-BQ space what you can’t get in BQ space. Things like a particular issuer, coupon rate, investment size and yield are all good reasons for considering non-BQ municipals.
If you’re looking for additional investment in the muni sector but have felt hamstrung by the limitations of BQ price and availability, consider the advantages that non-BQ bonds can provide, especially in this low tax, low cost of funds environment. If you have an interest, please contact your CenterState representative.
Agency Indications — FNMA / FHLMC Callable Rates
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