HJ Sims Market Commentary: Floors and Ceilings

by Gayl Mileszko

Markets around the world were stunned when the gold standard credit rating of the United States of America was downgraded by Standard & Poor’s (“S&P”) from triple-A to AA+ after the close on Friday, August 5, 2011. S&P had issued a negative outlook in July after warning that failure to reach a sufficient compromise on slashing the deficit would risk this action. They boldly told the world that “the effectiveness, stability and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges”. Although an agreement had already been reached to cut $2.1 trillion from future deficits, S&P pressed on with a rating cut, unlike its counterparts at Moody’s and Fitch who stopped at issuing negative outlooks. S&P cited Congressional resistance to new revenue measures and uncontrolled growth of entitlements, and characterized the U.S. political system as dysfunctional and the federal debt as growing at an unsustainable rate and amount. Washington lawmakers fired back, accusing the rating agency of trying to justify its reputation after having misrepresented its objectivity and independence in the years leading up to the financial crisis when inflated ratings were issued on structured debt products. Amid the Sturm und Drang between July and August, the S&P 500 dropped 17%, and the 10-year Treasury plummeted 108 basis points.

S&P’s U.S. Credit Rating Still Below That of Lichtenstein

The debt and deficit and, arguably, the dysfunction in Washington have only magnified since 2011. S&P’s downgrade remains in place; the AA+ rating places the U.S. credit on par with Austria, Finland, Hong Kong, New Zealand and Taiwan, and a notch below top-rated Germany, Australia, Switzerland, Denmark, Canada, Luxembourg, Norway, Netherlands, Sweden, Singapore and Lichtenstein.  Congress and the White House are currently at a standoff eerily similar to the one in 2011 when the Republican Party had just gained control of the U.S. House and demanded that the Democratic President agree to future spending cuts in exchange for an increase in the debt ceiling. Extraordinary measures to amass funds needed to meet federal obligations without the issuance of new debt had been in place for three months and the 75th Secretary of the Treasury had been warning for seven months that a failure to raise the debt limit would precipitate a default by the United States and have catastrophic economic consequences that would last for decades. Even if debt payments were prioritized over all others, the Secretary warned, failure to raise the debt ceiling would force the government to reduce spending by as much as 10 percent of GDP overnight and send the country into a recession.

Debt Stands at 120 Percent of U.S. GDP

The U.S. is basically the only country in the world that requires a separate vote on raising the debt ceiling, the total amount of money the government is allowed to borrow. The Congress has sole authority over raising it.  The first limit was set at $11.5 billion in 1918 and the first aggregate limit came in 1939 at $45 billion, covering almost all government debt. Eighty-four years later, the 78th Treasury Secretary has notified Congress that the debt ceiling of $31.38 trillion, last raised on December 16, 2021, will be reached on January 19. Approximately $24.5 trillion of the total is debt held by the public, and the remainder is comprised mostly of debt held in trust funds. Together, this debt constitutes an amount equivalent to 120% of the nation’s gross domestic product. House Speaker Kevin McCarthy has promised his members that he will not move to raise the current limit without extracting spending concessions from President Biden. But the White House says that the President will not negotiate at all over the debt limit. Proposals to mint a trillion-dollar coin and temporarily prioritize debt service payments and other mandatory spending have resurfaced as distractions to multiple other headline events focused on classified documents, inflation, economic data, Fed rate hikes, the pandemic, Ukraine support, border security and more. Attuned to the impasse on the Hill, Janet Yellen has announced the first batch of extraordinary measures to pay all of our incoming bills — most significantly including interest payments due on the debt.

Twelve-Plus Years of Showdowns

Bond and stock markets are following developments in the negotiations at both ends of Pennsylvania Avenue. Veteran traders have witnessed many similar debates, standoffs and showdowns over the years, many taking place on the House floor with cameras rolling. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend or revise the definition of the debt limit. Since 2002, with few exceptions, there has been at least one vote a year. The heated debate in 2011 that brought the nation two days from default produced one of the worst weeks the stock market had seen since the financial crisis. There is no doubt that there will be more drama during this year’s overdue debate on federal spending priorities and the need for significant debt reduction, but we believe that the House and Senate will eventually vote to raise the limit to ensure that we will never default on our sovereign debt.

Perspective and Insight to Come at the Sims Late Winter Conference

Among those who have written on the modern era of fiscal standoffs is Neil Irwin, the chief economic correspondent at Axios. He sees some warning signs that this debt limit battle could be different, that ugly days may be in store later this year. We will hear more of his views on this and other topics at the HJ Sims Late Winter Conference next month. Neil will be delivering a keynote address to attendees from the senior living and charter school industries who will gather at the Hyatt Regency Sarasota between February 14 and 16 for educational sessions, networking and a host of outdoor activities in the Florida sun. For further information and registration details, please contact your HJ Sims representative.

Multiple Market Movers This Week

With the debt ceiling still somewhat of a distant backdrop, markets this week are monitoring developments at the World Economic Forum in Davos, Switzerland while following seven Treasury auctions, parsing the remarks being made by nine Federal Reserve officials, dissecting the first of the last quarter’s corporate earnings reports, and noting economic data being reported in manufacturing, producer prices, retail sales, and housing starts. High yield corporate bonds are having their best start to the year since 2009. So far $10.3 billion of new issues have come to market and index returns are up 3.89%. The municipal bond calendar is picking up with more than $8 billion of sales on tap for this holiday-shortened week. Borrowers and investors alike, completely floored by the record level of municipal bond mutual fund outflows last year, have just seen the hopeful sign of a turnaround.  After 20 straight weeks of outflows, muni fund flows turned positive with $1.5 billion of net investment according to Refinitiv Lipper.  This could produce momentum and entice some borrowers off the sidelines. But many strategists caution that we will see a lower average number of offerings in this first quarter, and perhaps into the second quarter, until after the Fed Funds rate peaks. This adds to the supply/demand imbalance that is fueling price increases and producing month to date returns of 2.53%. Current CME probabilities reflect futures expectations for a terminal rate of 4.75% at the March 22 Federal Open Market Committee meeting.

Recent Municipal Bond Issuance: Charter Schools

Last week’s municipal calendar totaled $4.7 billion and the slate featured several charter school financings. The Arizona Industrial Development Authority sold $17.7 million of Ba1 rated revenue bonds for Benjamin Franklin Charter School structured with 2058 term bonds priced at 5.50% to yield 5.58%. The Authority also issued $16 million of BB+ rated revenue bonds for Academies of Math and Science which also included 35-year term bonds that priced with a coupon of 5.50% to yield 5.61%.

Rallies So Far in 2023

At this writing, we are nine trading days into the new year. With few exceptions, including thermal coal, natural gas and nickel, all down more than 5%, almost every asset class has rallied.  Stock market volatility as measured by the VIX has dropped 15% from year-end 2022. Bond market volatility, as gauged by the MOVE Index is down more than 6%. The Dow at 34,302 is up 3.5%. The S&P 500 at 3,999 is 4% higher. The Nasdaq at 11,079 has gained 6% and the Russell 2000 at 1,887 is 7% higher. Gold prices at $1,920 is up more than 5%. Oil is basically flat at $79.86 while Bitcoin at $19,259 has risen more than 16%.

Inversions, Yields and Opportunities

On the bond market side, we are still seeing an inverted yield curve. The 12-month Treasury yield at 4.66% and the 3-month at 4.57% are both higher than the 2-year at 4.23%, and these short maturities yield more than the 10-year at 3.50% and the 30-year at 3.61%. The 10-year has dropped 39 basis points since the start of the year, and the 30-year yield is down 35 basis points. The 10-year Baa corporate bond is at the top of the rally winners with yields have plummeting 44 basis points to 6.00%. On the tax-exempt side, the 1-year AAA municipal general obligation benchmark yield at 2.43% stands higher than the 11-year maturity at 2.40%.  The 2-year yield has fallen 33 basis points to 2.27%. The 10-year at 2.31% is down 32 basis points. The 30-year at 3.24% is lower by 34 basis points. HJ Sims traders are finding good value and yield for our income investors in the corporate, preferred, and muni sectors.  We note that taxable munis have rallied more than 5% so far this year. Please reach out to your HJ Sims representative for opportunities tailored to the needs and goals that fall between your risk, return and price floors and ceilings.

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