Economic Perspectives: Federal Debt: A Fiscal Year End Update
FAQs on the Markets and Economy
The Fed raised the federal funds rate by just 25 basis points (bps); what do you make of that?
The Fed continued to downshift the size of its interest rate increases. The recent move was an increase of 25 bps to 4.625%. That move follows a 50 bps hike in December and four hikes of 75 bps before that (see chart).
The Fed appears to have moved to the next stage of reducing monetary policy. Stage one was raising interest rates at a breakneck clip to push the funds' rate high enough into the restrictive territory. Now that some sectors of the economy are slowing, the Fed is moving into the second stage, where they “fine-tune” the funds' rate. Finally, at some point, it will reach the third stage, where the Fed will maintain the funds' rate at a specific level.
At the press conference following the Federal Open Market Committee (FOMC) meeting, Powell projected his hawkish resolve. He wanted to clarify that the Fed is not done with raising interest rates: “it would be very premature to declare victory [on inflation].” The next FOMC meeting is on March 22. There will be two more inflation reports and two more labor reports before that meeting. We expect the Fed to raise the funds' rate by another 25 bps at that meeting.
The labor report was really strong. What does it mean for Fed’s policy?
There are a whole lot more people working than previously believed.
Nonfarm payrolls rose an eye-popping 517,000 in January. In addition to that, the report came with an upward revision in November and December of 71,000, followed by annual revisions that showed the growth of the 12 months ending last March was revised up by 568,000. Job growth was well diversified among industries. Even the beleaguered construction industry, in which high mortgage rates have been beaten down, continues to hire workers (see chart). And the unemployment rate fell to 3.4%, the lowest level since 1969.
The economy is still not in a recession, and this report probably pushes out the start of the expected recession, but it doesn’t reverse the direction of a slowing economy. The Fed is singularly focused on inflation and will continue with its planned interest rate increases (25 bps in March and another 25 bps, probably in May). The higher interest rates will continue to pressure consumers to slow demand and businesses to reduce investment.
Is the latest debt ceiling standoff a concern for investors?
On January 19, the U.S. government officially exceeded its debt limit of $31.4 trillion, forcing the Treasury Department to begin "extraordinary measures," including suspending the sale of certain government securities, to ensure the government meets its obligations.
A default on the federal debt is something that has never happened in U.S. history. The implication of such an event for financial markets and the overall economy is hard to quantify, but would likely be significant, including spiking bond yields, higher borrowing costs, falling consumer confidence, financial market turmoil, and recession.
So far, there's little sign that the market is worrying too much about the threat of a serious crisis. However, with both parties holding small majorities in Congress, getting a deal done in the current political environment is likely to prove more difficult than normal, and we expect market sentiment to grow more negative at some point ahead. In 2011, a chaotic fight over raising the debt limit pushed the federal government near default, caused a sharp stock market downturn, and ultimately prompted credit rating agencies to downgrade the national credit rating.
Extraordinary measures won’t last forever, with the current best guess that Treasury will exhaust its resources sometime between late summer and early fall. Nonetheless, there is historical precedent for Congress to come together last minute, typically with concessions from both sides. Since 1960, the debt ceiling has been raised 78 times in the U.S., including 20 times since 2001 alone. This will likely prove to be the case this time, with a deal to raise the ceiling ultimately agreed to alongside a combination of modest spending cuts and tax increases acceptable to both parties.
However, we are closely watching developments in Washington to assess the risk of the current standoff to both the economy and financial markets. From an investment perspective, investors should be aware the current standoff could be another source of volatility for financial markets in the coming months. However, so long as a resolution is eventually reached, these episodes tend not to be a long-term driver of market performance. In the last several instances of more severe debt-ceiling showdowns, including 2011, markets were higher in the 12 months after the debt ceiling was resolved.
How have municipal bonds fared to begin the new year?
Municipal bond investors have good reason to cheer as the asset class is off to a healthy start this year.
The performance of investment grade (IG) and high yield (HYM) municipal bonds has benefitted from a bounce in prices from various technical trends occurring within the market. Per Bloomberg, the total returns of the IG and HYM indices were 2.87% and 4.44%, respectively, last month (January), which were the highest monthly gains since 2009.
Cumulative returns since November 2022 have recovered more than 50% of the losses incurred by municipal investors during the first 10 months of last year.
U.S. Treasury yields declined by more than 35 bps last month, helping to drag down municipal yields across the curve. At the same time, municipal bond mutual funds experienced net inflows for three consecutive weeks, a sharp reversal from record outflows recorded in 2022. Further supporting the municipal bond market is an unusually quiet supply calendar that continues to underwhelm investor demand. Net negative supply (i.e., the difference between supply and maturities/redemptions returning to investors) of more than $17 billion in January is expected to persist at least into February, with a similar deficit anticipated, per Bloomberg.
While municipal investors continue to assess relative value opportunities across the curve and within market sectors, nominal yields remain interesting, with the yield-to-worst on IG and HYM indices above 3% and 5.4%, respectively. Despite recent compression in the yield curve, municipal investors are favorably positioned to capture attractive tax-efficient cash flow. Municipal bonds continue to offer income, relative safety, and portfolio diversification attributes for a cross-section of investors, particularly those with a longer-term view.
Important Disclosures
The information presented does not involve the rendering of personalized investment, financial, legal or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial infor-mation. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been inde-pendently verified, and its accuracy or completeness cannot be guaranteed.
Any opinions, projections, forecasts and forward-looking statements presented herein are valid as of the date of this document and are subject to change.
There are inherent risks with equity investing. These include, but are not limited to, stock market, manager or investment style risks. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices.
Investing in international markets carries risks such as currency fluctuation, regulatory risks and economic and political instability.
There are inherent risks with fixed income investing. These may include, but are not limited to, interest rate, call, credit, market, inflation, government policy, liquidity or junk bond risks. When interest rates rise, bond prices fall. This risk is heightened with in-vestments in longer-duration fixed income securities and during periods when prevailing interest rates are low or negative.
Investing involves risk, including the loss of principal.
As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.
Past performance is no guarantee of future performance.
This material is available to advisory and sub-advised clients, as well as financial professionals working with City National Rochdale, a registered investment advisor and a wholly-owned subsidiary of City National Bank. City National Bank provides investment management services through its sub-advisory relationship with City National Rochdale.
Non Deposit Investment Products are: Not FDIC Insured, Not Bank Guaranteed, May Lose Value
The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Readers are cautioned that such forward-looking statements are not a guarantee of future results, involve risks and uncertainties, and actual results may differ materially from those statement. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.
Past performance or performance based upon assumptions is no guarantee of future results.
Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.
Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as on the date of this document and are subject to change.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.
This material is available to advisory and sub-advised clients, as well as financial professionals working with City National Rochdale, a registered investment adviser and a wholly-owned subsidiary of City National Bank. City National Bank provides investment management services through its sub-advisory relationship with City National Rochdale.
INDEX DEFINITIONS
S&P 500 Index: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading pub-licly traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market cap because there are other criteria that the index includes.
Muni Bond: A municipal bond is a debt security issued by a state, municipality or county to finance its capital expenditures, including the construction of highways, bridges or schools. These bonds can be thought of as loans that investors make to local govern-ments.
Bloomberg Barclays U.S. Corporate High Yield Bond Index: measures the USD denominated, high-yield, fixed-rate corporate bond market.
Dow Jones Select Dividend Index: The Dow Jones U.S. Select Dividend Index looks to target 100 dividend-paying stocks screened for factors that include the dividend growth rate, the dividend payout ratio and the trading volume. The components are then weighted by the dividend yield.
CBO: A collateralized bond obligation (CBO) is a type of structured debt security that has investment-grade bonds as the underlying assets backed by the receivables on high-yield or junk bonds.
Moody’s: Moody’s Corporation (MCO) is the holding company that owns both Moody’s Investors Service, which rates fixed income debt securities, and Moody’s Analytics, which provides software and research for economic analysis and risk management. Moody’s assigns ratings on the basis of assessed risk and the borrower’s ability to make interest payments, and its ratings are closely watched by many investors.
Penn Wharton Budget Model: Penn Wharton Budget Model’s (PWBM) tax policy simulator allows policymakers, members of the media, and the general public (“users”) to see the impact that potential reforms to tax policy will have on many the economy and the federal budget.
NDMC: National Drought Mitigation Center (NDMC) The National Drought Mitigation Center’s mission is to reduce the effects of drought on people, the environment and the economy by researching the science of drought monitoring and the practice of drought planning.
NOAA: The National Oceanic and Atmospheric Administration (NOAA) is an American scientific and regulatory agency within the United States Department of Commerce that forecasts weather, monitors oceanic and atmospheric conditions, charts the seas, conducts deep sea exploration, and manages fishing and protection of marine mammals and endangered species in the U.S. exclusive economic zone.
USDA: The United States Department of Agriculture (USDA) is the federal executive department responsible for developing and executing federal laws related to farming, forestry, rural economic development, and food.
The SIFMA Municipal Swap Index: The Securities Industry and Financial Markets Association Municipal Swap Index is a 7-day high-grade market index comprised of tax-exempt Variable Rate Demand Obli-gations (VRDOs) with certain characteristics. The Index is calculated and published by Bloomberg. The Index is overseen by SIFMA’s Municipal Swap Index Committee.
CalPERS: The California Public Employees’ Retirement System, also known as CalPERS, is an organization that provides numerous benefits to its 2 million members, of which 38% are school members, 31% public agency members, and 31% state members.
4Ps: The 4P analysis is a proprietary framework for global equity allocation. Country rankings are derived from a subjective metrics system that combines the economic data for such countries with other factors including fiscal policies, demographics, innovative growth and corporate growth. These rankings are subjective and may be derived from data that contain inherent limitations.
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