The market now expects rate hikes. Here is what that means for your muni portfolio.
The Signal
Something that hadn’t been on the table for months is now the market’s base case: a rate hike.
May’s nonfarm payrolls came in at 172,000 — the strongest three-month advance in more than two years — and the unemployment rate held steady at 4.3%. Federal Reserve Bank of Cleveland President Beth Hammack said the report reaffirms that the labor market “appears to be roughly in balance,” adding that 4.3% unemployment is “right around my definition of full employment.” She noted it may soon be appropriate to raise interest rates. The market is now pricing zero cuts over the next several months, with the street assigning a 100% probability of a 25 basis point hike at the December 2026 meeting.
Three months ago, the conversation was about cuts. Today it is about hikes. Through all of it, the municipal bond market has held its ground. New issuance continues to be absorbed, and we see no reason to change our positioning.
We have been guiding clients through this rotation for several weeks. The May jobs data confirms what the market has been slowly repricing — and munis have responded with the kind of resilience that rewards patient, quality-focused investors.
What’s Driving It
Labor market strength is rewriting rate expectations
May’s jobs report was the clearest sign yet that the labor market may be emerging from a prolonged period of lackluster hiring. Nonfarm payrolls rose 172,000 last month, with upward revisions to the prior two months, representing the strongest three-month advance in more than two years. With the unemployment rate holding at 4.3%, the Fed now finds itself in a labor market that is, by its own measures, at or near full employment. The Fed’s posture is to hold and watch inflation data — but a hike is explicitly on the table, and the market is pricing it accordingly.
Inflation has two engines: the Iran Conflict and the AI buildout
Energy prices tied to the Iran Conflict continue to push inflation higher. A second force is now drawing equal attention: the AI revolution. Surging demand for memory chips and data center infrastructure is driving technology costs higher, with knock-on effects in consumer electronics. Bloomberg’s forecast for the May Consumer Price Index is 4.20% year-over-year — the highest since the post-COVID surge. The expectation is that these twin pressures persist into 2027, before oil transitions from an inflation driver to a drag and the headline number eases back toward 2%. New Fed Chair Warsh’s view that inflation will eventually trend down gives the Fed space to hold through the summer — and we think they will use it.
Treasury markets are tracking Iran Conflict signals closely — and reversing quickly.
Treasuries partially recovered losses this week after reports of a ceasefire between Israel and Iran briefly eased upward pressure on oil. The two-year yield retreated from near 4.20% — its highest since February 2025 — to approximately 4.13%, with the ten-year trading around 4.54%. The reprieve proved short-lived: hostilities resumed, military strikes continued on both sides, and yields retraced. The pattern is the same one we have described for clients over the past several weeks — ceasefire signals move markets, and their reversal moves them back. The Iran Conflict remains unresolved, and the volatility it generates is a feature of this market, not a temporary condition.
The trade picture is stabilizing, and the muni math remains compelling
The U.S. trade deficit narrowed 1.2% in April to $55.9 billion, as a surge in oil exports helped offset rising imports of data center equipment. On the muni side, Paul Malloy, head of municipals at Vanguard, sees the combination of attractive yields and strong credit fundamentals setting the market up for a solid second half. Investors in the highest tax bracket can currently collect a broad muni-market yield of 3.62% — equivalent to 6.1% on a taxable security. That compares favorably against U.S. corporate bonds yielding 5.26%, with a higher default rate. We continue to see yields above 4.40% on high-grade munis as a compelling entry point.
Our Take
The macro story has rotated materially over the past 90 days. Rate cuts were the consensus at the start of the second quarter. Today, the street assigns a 100% probability of a rate hike by year-end. We think that read is running ahead of the data — but the direction of travel is no longer ambiguous. Inflation is running hot, the labor market is strong, and the Fed has made clear it will not move prematurely in either direction.
Our base case remains unchanged: no rate action through the summer. Supply shocks tied to the Iran Conflict are still working through the pricing system, and we expect certain disinflationary forces to begin offsetting cost-push pressures over time. The Fed, under Chair Warsh, has the cover to hold. We believe it will.
The Iran Conflict remains the primary wildcard. The brief ceasefire signal this week illustrated the pattern we have been tracking: accord headlines pull yields lower, resumed hostilities push them back. Both moves create opportunity for disciplined buyers. We are watching and prepared to act on either.
Within that environment, the municipal market has performed with notable resilience. New issuance is being absorbed. Credit fundamentals are strong. And the taxable equivalent yield on high-grade paper continues to compare favorably to corporate alternatives. We are, however, watching pockets of the high-yield market carefully: some transactions are not getting done, reflecting both credit discipline from lenders and structural concerns with certain underlying assets. That selectivity is appropriate and healthy. It is also a reminder that underlying structure — not headline yield — should drive decisions in this environment.
We continue to see yields above 4.40% on high-grade munis as a good entry point. Our focus remains on quality, essential-service, and insured paper.
Recommendations
Stay the course on high-grade munis
The market’s shift toward rate hike expectations has not disrupted the fundamental case for quality muni paper. Yields above 4.40% on high-grade issues remain a compelling entry point, and we continue to be buyers at current levels. Focus on essential-service and insured paper with strong revenue durability.
Revisit your taxable equivalent yield
With the broad muni market yielding 3.62% — equivalent to 6.1% taxable for investors in the highest bracket — the comparison to corporate bonds at 5.26% is favorable, even before accounting for the higher default rate on the corporate side. If you haven’t benchmarked your muni allocation against taxable alternatives recently, now is the right time.
Approach high yield with caution
Several high-yield transactions are failing to close, reflecting structural concerns and tighter credit standards from lenders. This is not the environment for reaching for yield. Stick with quality, and let underlying structure guide decisions.
Reach out if you’d like to discuss this in the context of your portfolio
The rate environment is shifting, and the taxable equivalent math has real implications for your specific situation. We are actively watching and prepared to act.
Let’s Talk
If you would like to discuss any of the above in the context of your portfolio, reach out. This market environment rewards preparation — and that is exactly what we are here to help with.
