Wed 03/15/2023 16:50 PM
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Ahead of the March meeting of the Federal Open Markets Committee, or FOMC, next week, swaps for futures on the Federal Funds Effective Rate are pricing in a 100-bps cut to the benchmark by year-end, said fixed income, municipal bond and rate strategists who spoke to Reorg.

During the FOMC meeting next week, expectations are still weighted toward a 25-bps rate hike, bringing the effective funds rate to 4.75% to 5%, said the strategists. However, because of turmoil in the U.S. financial sector and the collapse of two regional banks, Silicon Valley Bank and Signature Bank, the market is expecting a strong caveat that the FOMC will be monitoring the conditions of financial institutions, establishing a case for potential cuts for later this year, they added.

The implied probability of cuts to the Effective Funds Rate based on Fed funds futures predicts an implied rate of 3.7% on Jan. 31, 2024, according to a futures trader and a rate strategist. Meanwhile, the mid-price for a Federal Funds swap was 425 bps to 426 bps this morning after dipping to a low of 391 bps, implying a similar expectation that the FOMC will cut the effective fund rates by the end of the year, said the futures trader.

“Market is telling you that the hikes are over and cuts are to start in September,” said George Goncalves, head of U.S. Macro Strategy at MUFG. “The rates market is telling you that rates will have to come down 100 bps from where we are now.”

An earlier indication of where rates might go could be an announcement from the European Central Bank tomorrow, Thursday, March 16, during its monthly press conference, added the futures trader. Until then, however, the streak of announcements from ratings agencies today portend more volatility for the U.S. financial system.

S&P Global Ratings today lowered to below investment grade the rating of First Republic Bank, to BB+ from A-. Fitch Ratings also downgraded the bank, to BB from A-, bringing it one notch lower. Yesterday, Tuesday, March 14, Moody’s placed UMB Financial Corp. on review for downgrade “all long-term ratings and assessments of UMB Financial Corporation and its bank subsidiary, UMB Bank, N.A.” UMB Bank serves as trustee for many distressed U.S. municipal bond issuances.

The downgrades of First Republic were coincident with an announcement this morning from First Republic that it had worked with the Federal Reserve and JPMorgan to increase liquidity to “more than $70 billion in funding.” First Republic’s access to the Federal Reserve’s new Bank Term Funding Program, or BTFP, was limited because 69% of its assets were municipal securities that the Federal Reserve would not accept as collateral under the BTFP’s lending parameters.

There have been some liquidity concerns regarding banks holding sizable amounts of munis in their portfolios, particularly with regional banks, as they own about $140 billion worth of munis, including a substantial portion of taxables, according to a report from Barclays earlier this week.

But the recently failed banks already sold off their munis exposure late last year or at the beginning of this year, so the impact of a potential munis selloff as a way to raise capital “will likely be muted,” according to the Barclays report. Silvergate sold off $4 billion in munis in the fourth quarter of 2022, and SVB sold a portion of its $7.4 billion munis holdings early in the first quarter of 2023, the report states.

Munis yields typically mirror the moves in the Treasurys, but that has not been the case following the SVB announcement last Friday, March 10, since current market conditions are more likely to affect Treasurys rather than munis, sources say. The 10-year Treasury was at 3.9% last Thursday, March 9, and has since dropped 47 bps as of yesterday’s close. The two-year Treasury over the past week is down about 120 bps, while the two-year munis yield was down only 28 bps.

This reflects a move down in munis, but it was not sharp enough to cause a stir in the primary market, sources say. If yields continue to come down, some higher-yielding names might come back to the market to take advantage of cheaper borrowing opportunities, and high-credit names will continue to perform because they are usually not rate-sensitive, says a high-yield investor.

“Munis and Treasuries are correlated until they are not,” said Goncalves. “The muni/Treasury ratio will widen during times of stress, … and a rate rally under these conditions is typically not good for credit. This is not a healthy rate rally.”

--Seth Brumby, Hoa P. Nguyen
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