Inflation and jobs are cooling. Here’s what that means for your muni portfolio.
The Signal
This week’s data leans one direction: cooling. Core CPI matched the slowest annual pace since March 2021 at 2.5%, and nonfarm payrolls fell by 23,000, with a net 103,000 jobs cut from May and June estimates. Some, including us, are not expecting a rate increase for the balance of the year, though it will be hard to predict with confidence as long as the conflict in Iran continues.
For muni investors, this backdrop matters less for what it says about the Fed’s next move and more for the opportunity it may be creating on the long end. We continue to watch for periods when long end, five handle coupon investment grade paper trades below par, a rare setup that has occurred only six times over the past 20 years and can offer tax adjusted yields that rival equity market returns. We unpack that opportunity, along with three other threads driving the market this week, below.
We noted last week that Chair Warsh’s Fed is giving the market less forward guidance than investors have grown used to. This week, the data did the talking instead: a cooling inflation print and a weak jobs report moved the market more than any Fed signal could have.
What’s Driving It
Growth and Inflation Data Are Cooling, But Iran Keeps the Calculus Complicated
Core CPI rose 0.2% in July, matching the slowest annual pace since March 2021 at 2.5% year over year, according to Bureau of Labor Statistics data released this week. Nonfarm payrolls fell by 23,000, and combined downward revisions to May and June cut a net 103,000 jobs from what had originally been reported. The unemployment rate fell to 4.1%, but largely because labor force participation continued to slide rather than because more people found work. Existing home sales also slipped to a three-month low of 4.06 million annualized units in July, down 1.7% from June, as elevated prices and mortgage rates continued to weigh on buyers.
Taken together, this data supports the case for the Fed to hold rates steady for the balance of the year. We would caution, however, that the Iran conflict keeps energy prices as a wildcard that could reaccelerate inflation and complicate that view quickly.
Fed Independence and Dollar Diplomacy Are Being Tested at Once
President Trump downplayed the frequency of his conversations with Federal Reserve Chairman Kevin Warsh this week, insisting the two have spoken only once, briefly, since Warsh joined the Fed, despite reporting that the contact has occurred more often. We have never believed the President will directly influence the Fed’s decisions, though Trump’s preference for lower rates is well known and has likely reached Warsh through multiple channels.
A similar test of credibility is playing out in currency markets. Treasury Secretary Bessent’s pledge of open ended support for the yen ran into skepticism this week after the currency gave back roughly half its post intervention gains, falling past 159 per dollar. We expect munis would likely respond positively to this dynamic while taxable securities could see more pressure from rising Treasury yields. Munis were up modestly, around 1 basis point, when the news broke Monday.
A Rare Window May Be Opening in High Grade Munis
In our view, muni investors should watch closely for periods when long end, five handle coupon investment grade paper trades below or at par. This is an uncommon setup, occurring only six times over the past 20 years, and one that has historically offered tax adjusted yields competitive with equity market returns. A move into the 5% range for High Grade paper would represent a compelling entry point for capital deployment, and we would look to be active buyers at those levels.
Supply Is Heavy and Absorption Is Strong, But Credit Selection Still Matters
Investment grade bond issuance continued at a record pace this week, with 19 issuers pricing new deals, the busiest week in seven months. Municipal issuance has been similarly heavy this year, and the market has continued to absorb it well. The world’s busiest airport, Hartsfield Jackson Atlanta International, is the latest example, coming to market with more than $1 billion in bonds, roughly $699 million subject to the alternative minimum tax and $391 million non-AMT, to fund improvements at Delta’s largest hub. We remain bullish on airport related debt at large hub airports such as Atlanta.
Strong absorption is not the same as undifferentiated credit quality, however. Moody’s downgraded George Washington University to A2 from A1 this week, citing financial strain tied to its real estate heavy endowment and losses at its academic medical center. Investors buying higher education paper should stay mindful of underlying credit quality; DRL continues to hold positions in the sector, largely within insured paper.
Our Take
Taken together, this week’s data points to a market that is cooling without falling apart. Inflation is moderating, the labor market is softer than the headline unemployment rate suggests, and municipal issuance continues to clear without difficulty. None of that changes our core positioning: we remain buyers of high grade, insured, and essential service paper at current levels.
The two variables we are watching most closely are the Iran conflict’s effect on energy prices, which could reverse this week’s inflation progress, and the credibility of the Fed and Treasury as they navigate political pressure and currency intervention at once. Neither risk changes our positioning today, but both could shift the picture quickly.
Munis have historically weathered crosscurrents like these well, and this week’s data gives us little reason to think that changes. We will continue watching how the market prices growth, inflation, and credit risk in the weeks ahead, and will keep you informed as the picture develops.
Recommendations
Watch for high grade munis trading below or at par.
This is a rare setup that has occurred only six times over the past 20 years. Should the market move into the 5% range on the long end, we would look to act on tax adjusted yields that could rival equity market returns.
Favor insured and essential service credits within higher education.
This week’s downgrade at George Washington University is a reminder that credit selection matters even in a market that is absorbing heavy supply well. We continue to concentrate our higher education exposure in insured paper.
Stay attentive to airport and large hub infrastructure paper.
Deals like Atlanta’s continue to offer the scale and structure we find attractive in the sector. We remain bullish on airport related debt, particularly at large hubs.
Expect rate uncertainty to persist as long as the Iran conflict continues.
Cooling inflation and labor data support our view that a rate increase is unlikely this year, but that view could change quickly if energy prices reaccelerate. Reach out if you’d like to discuss this in the context of your portfolio.
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.
