This morning we were welcomed by green screens as Treasuries advanced following weeks of selling.  Nevertheless, Day-to-day volatility remains high in the fixed income markets with the war in the Middle East continuing to dominate headlines and what the media is referring to as the biggest oil supply shock in history.  The war is now in its second month and the rate cuts investors have been anticipating over the past year are appearing increasingly less likely.  Not surprisingly, pricing in the Fed funds futures market has fluctuated dramatically over this past week with current pricing indicating only the chance of a cut over the next year.

Day-to-day volatility remains high in the fixed income markets with the war in the Middle East continuing to dominate headlines.  At the Fed’s meeting last week, the Committee decided to maintain the target range for the federal funds rate at 3-1/2 to 3-3/4 percent.  The Fed Chair expressed a cautious outlook, noting that current inflation levels are being driven by factors pre-dating the conflict in Iran and estimating that between half and three-quarters of total core inflation is actually tariffs.  In addition, the Chair commented that typically the Fed looks through energy shocks and expects to see inflation improving around the middle of this year.  The current uncertainty has resulted in a choppy Fed funds futures market with current pricing not indicating any rate cuts over the next 12-months.

The war in the Middle East continues to dominate headlines, leading to a high degree of volatility in oil prices and pressuring the stock and the bond markets alike.  The Fed funds futures market is currently indicating the Fed will not adjust the overnight lending rate at its meeting later this week.  Due to the high degree of uncertainty from the war in the Middle East, this is not surprising.  Furthermore, current pricing anticipates the Fed will hold rates steady until January of next year.  

Bond investors are currently asking for more compensation for the risk of holding long-dated Treasuries.  Over the past week, Treasury yields have increased by approximately 16 bps for the 30-year maturity while the extreme short-end, around 1-month, remains virtually unchanged.  Munis have responded similarly, although to a lesser degree, with rates roughly 9 bps higher on the long-end.  However, the largest moves in the municipal scale were in the intermediate maturities from 8 to 12-years.  As a result, municipal/Treasury ratios have become more appealing in the in the 5 and 10-year tenors with ratios on the long-end and short-end becoming more rich, characterized by lower relative yields.  Currently, ratios for maturities shorter than 1-year are back in the 50’s while 30-year munis are now yielding less than 90% of equivalent Treasuries.

The war in the Middle East continues to draw the markets focus as bond traders attempt to manage inventory exposure with oil prices now through $100 per barrel.  Last week’s softening labor market data from the Bureau of Labor Statistics and skyrocketing oil prices have fixed income markets nervous that energy costs could trigger a surge in inflation while constricting economic growth.  Not surprisingly, Fed Funds Futures are now implying only one rate cut over the next 12-months and another cut 12-months later. 

This morning, Treasury bonds sold-off amid surging oil prices as inflation fears drove yields higher.  As conflict in the Middle East escalates, disruption in tanker activity and supply concerns will remain in-focus.  Typically global conflict will place downward pressure on rates as investors seek safety; however, in a market already sensitive to inflation and the potential for further rate cuts oil driven inflation concerns have unsettled investors.  

Trading in munis has been muted today, with investors cautiously waiting for additional information.  Over the past month munis have generally lagged the rally in Treasuries, particularly for tenors past 2-years.  The result has been a Treasury curve that has flattened about 18 bps while the muni curve steepened by about 6 bps.  Recent activity is the continuation of a long-term trend in muni/Treasury ratios with ratios at the extreme short-end becoming more rich (less appealing) and ratios on the long-end becoming cheaper (more appealing).  Currently, ratios for maturities shorter than 1-year are yielding 58.5% of their Treasury equivalents while 30-year munis are yielding over 90% of equivalent Treasuries.  

Despite the headlines and anxiety leading up to last week’s supreme court ruling, which determined the reciprocal tariffs are illegal, the bond market’s response was fairly measured.  The Treasury market initially reacted with longer dated yields jumping approximately 6 basis points to 4.75%, before settling back as more information emerged.  The muted response was partly due to the markets anticipating the ruling by pricing-in the outcome in advance and partly due to the potential for replacement tariffs.  However, there remains significant uncertainty about when, or if, the billions in collected tariffs will be refunded.  Should the tariffs be refunded, the bond market currently anticipates the burden will be shifted to Treasury issuance and result in higher yields.

Last week we experienced the second government shutdown in just four months.  Following the approval of a spending package by Congress last Tuesday afternoon, funding for the majority of federal agencies was secured through September.  However, the package only funded Homeland Security through 2/13 (this Friday).  Keep in mind that Homeland Security isn’t just ICE, it also includes: TSA, FEMA, the Coast Guard and the Secret Service.  Should Homeland Security fail to receive funding, there is the potential for economic consequences and travel interruptions.

As a result of the shutdown, the Department of Labor was not able to issue its report on U.S. hiring in January, as scheduled last Friday.  The Bureau of Labor Statistics has rescheduled the release of The Employment Situation for this Wednesday, February 11 and CPI is scheduled to be released on Friday.  Unfortunately, the disruption in jobs data comes amid uncertainty regarding the strength of the labor market amid speculation about the timing of future interest rate cuts by the Fed.  Currently, the fed-funds futures market is anticipating a 25bps cut later this year in June.

Although the Federal Reserve’s rate decision was the primary economic event last week, the President’s announcement of his Fed chair nominee was arguably more impactful.  Markets had a mixed response to the selection of Kevin Warsh as the next Fed chair.  While his qualifications, particularly his experience as Fed governor from 2006 to 2011, were welcome news; there remains significant uncertainty about how he will balance the attentions of the Federal Reserve.  Fed policymakers have recently been divided on whether to prioritize labor market concerns or stubbornly high inflation that remains above target levels.

In addition, the partial shutdown of the government took effect on Saturday, as lawmakers struggle to find common ground on the funding of immigration agencies.  However, since Congress already passed half of this year’s funding bills last year, several federal agencies and programs continue to operate through September.  Nevertheless, the government shutdown still affects the departments of Defense, Homeland Security, Labor, Health and Human Services, Education, Treasury and Housing and Urban Development, in addition to agencies like the Securities and Exchange Commission.  Also, should the shutdown persists through the week, Friday’s Labor Department’s jobs report could potentially be delayed.  

This morning on the trade desk, accounts are distracted by Winter Storm Fern, which has created havoc from Texas to Maine with 24 states declaring emergencies.  In addition to widespread power outages, many roads and highways remain impassable and flight cancellations have reached levels not seen since the early days of the Pandemic.  Despite the inclement weather, Treasuries rose over the five to 30-year tenors resulting in yields dropping to their lowest levels since last week’s volatility.  Following a preliminary announcement by the Commerce Department of stronger than anticipated durable goods orders for November, gains were briefly pared.

Early last week, international events came into focus following instability in the Japanese bond market. Yields surged in the Japanese bond market following a pitch by Japanese Prime Minister Sanae Takaichi to cut taxes on food, which markets interpreted to mean increased government bond issuance.  The result was 40-year Japanese yields jumping to the highest level of any maturity of the nation’s sovereign debt in more than three decades.  In addition, escalating tensions over the control of Greenland with the threat of tariffs on European goods added to the melee.  The municipal bond market responded to the uncertainty with bonds selling-off.  As of the end of the day on Tuesday, MMD ultimately cut yields from 2bps in 2027-28 to 7 bps in 2041-56.