The Fed & Munis: Quite A Stretch

It has been quite a stretch. Two Fed (Federal Reserve) meetings, lots of Fed-speak, turmoil in financial markets, and re-pricing of certain asset classes to levels unexpected – all done in a violent and volatile way.

As my colleague John Mousseau just wrote, high-grade, tax-free municipal bonds have been trading above 5 percent. Taxable-equivalent yields on instruments like that are between 8.5 percent and 9 percent depending on your state residency and tax bracket. Think about it: if you are a US dollar-based American citizen in a higher tax bracket, where else can you get a compounded 8.5% on a fully taxable investment for a period of years? The question pertains to high-credit-quality alternatives. We see no more attractive alternatives.

At Cumberland, we have lengthened duration while moving to the buy side. We are buying where we can and altering accounts and mixes of accounts as we can. We are taking advantage of this very opportunistic time.

Why this bargain basement pricing occurred is a separate question. John Mousseau covered some of the reasons in his missive. Let me keep my comments directed at the Fed, since they were part of the problem. Hard as it is for them to admit an error, some in the Fed would now say they miscommunicated by sending a poor or confusing message. Others in the Fed would argue that is not the case and that the markets "misinterpreted" their message.

Misinterpreted? Hmmmm!

If you send a message to an audience and they do not interpret it the way you think they should have, who is wrong? Is it their fault because they did not hear you properly? Or is it your fault because you did not say it clearly? We can debate this forever. It is not important now. What is important is what happens next.

What do we know? We know that over the course of the last year the Fed has pointed to various unemployment rates ranging from 5.5 percent to 7 percent (most recently) to identify the point at which it will stop, taper, or diminish its purchasing of assets or stabilize and act to withdraw stimulus. Over time and taken together, the messages have been mixed to a disconcerting degree. At this point the unemployment rate target for the Fed is a mixed bag, and few market agents have confidence in any single number.

What else do we know? We know the present unemployment rate is higher than any one of those numbers. And we know that if you dig into the employment statistics deeply, you see that the recovery in employment, hence the recovery in labor income, is not robust. It is slow. Furthermore, we know that the federal budget sequester is about to cut the data-gathering enterprise along with much else, which means the numbers will be fewer and the picture they piece together perhaps less complete.

We know the Fed has a threshold in mind with regard to inflation. It said its longer-term target is 2 percent inflation, but it will permit inflation to go to 2.5 percent before it begins to trigger policy changes.

Ok. Where is the inflation rate now? It is a lot closer to 1 percent than 2 percent. It is headed down, not up. St. Louis Fed President, Jim Bullard, has articulated some worry about this. Bullard asks a valid question: Do we want to institute a policy change that markets will interpret as a reduction in the rate of stimulus when the inflation rate is below our target – and headed down? Notice how commodity prices are falling (copper is a clue to this price weakness).

Unfortunately, the rest of Bullard's colleagues on the FOMC (Federal Open Market Committee) have not addressed the question. We do not see consistent comments coming from the members of the FOMC about where they stand on this complicating factor of inflation's being below the FOMC target and falling.

What will the FOMC do if the inflation rate drops below 1 percent? What will they do if they are tapering while the inflation rate remains at 1 percent? How close to zero will they permit it to go before they change the way they are approaching monetary policy?

Can anyone answer those questions? Clearly the answer is no. Can anyone predict – with any pragmatically useful degree of precision – the policy pathways they will take through the unemployment-employment statistics? The answer is no. So we have confusion among market agents as a result of very mixed messages from the members of the FOMC.

Lastly, the US President knocks the knees out from under the outgoing Fed Chairman in a statement that appalled many. In our view, Ben Bernanke does not deserve such treatment by the President who appointed him. Bernanke has served his country as well as he could under severe circumstances and from a critical position. It is apparent when you see him that he is tired. He has worked diligently as a patriot. It appears that he wants to stop at the end of his term on January 31, 2014. He is attempting to pave the way for his successor, as he should.

So why, then, did the President need to kick him hard in a very uncomfortable spot? Markets saw that. Now they have no idea what is coming. They know there will be a new Fed Chairman. They expect the appointment to be announced sometime after Labor Day, because there is a confirmation process that must get underway. Discussions center on current Fed Vice Chairwoman Janet Yellen, former Fed Vice Chairman Roger Ferguson, former US Treasury Secretary Timothy Geithner and, perhaps, former Fed Vice Chairman Alan Blinder. Lawrence Summers can be added to that lineup, although many observers believe his confirmation would not be possible in the US Senate.

What do markets do when faced with rising uncertainty? How do they react to a confusing message as opposed to a clear one? A 6.5% percent unemployment rate and 2.5% percent inflation are clear milestones. Those numerical targets have now morphed into something quite slippery and confusing. So markets sold off and interest rates went up. The impact on the economy will slow the housing recovery. Just how much remains to be seen. Today’s GDP revisions point to how fragile this recovery seems to be.

We are going to talk more about this soon. We are currently scheduled to guest host Bloomberg TV's Surveillance on Friday, June 28, 2013, at 6:00 AM EST. The Fed will likely be the topic of our discussion with Sara Eisen, Scarlet Fu, and Tom Keene.

Between now and then, we are on the buy side of tax-free bonds. They are cheap. It is time to back up the truck and own them.

BY David R. Kotok