Yields eased today on dovish Fed talk. Here’s why the calm may not last.
The Signal
The municipal market has been caught up in a broader global bond selloff over the past few weeks, driven by rising oil prices and inflation concerns. Treasury yields moved higher alongside munis, and the move was not confined to the U.S.: the 10-year Japanese government bond briefly topped 3% for the first time in 30 years, and long-dated German and French yields reached their highest levels in 15 years.
Jeff Timlin, one of the market’s closer observers, has noted that the muni selloff has largely tracked the move in Treasuries, and that its orderliness reflects investors’ ability to withstand it. We agree, and we have continued to see buyers stepping into munis at these levels rather than stepping back.
This morning brought a different tone. Stocks rose and bond yields fell after Federal Reserve Governor Christopher Waller said he would support holding rates steady if progress toward the Fed’s 2% inflation goal continues, though he would consider a hike if inflation runs hot. His comments followed similar remarks earlier in the week from New York Fed President John Williams, who pointed to inflation trending down as the effect of tariffs fades. The Fed meets again September 15 and 16, after holding rates steady for five straight meetings.
We would not read too much into today’s dip. Jobless claims are out today, nonfarm payrolls tomorrow, and core CPI on September 11, all landing before the Fed’s decision. We expect yields to give back some of today’s move as the market works through that data, and we continue to view current levels as an opportunity for disciplined buyers.
We have been telling clients for weeks to watch the data calendar rather than any single day’s headlines. This week is simply the market catching up to that.
What’s Driving It
The Fed is not speaking with one voice.
Governor Waller and President Williams both leaned encouraging this week, but Governor Michael Barr struck a different tone, warning that the Fed should be prepared to raise rates if inflation does not subside, and that price pressures risk becoming entrenched after running above target for more than five years. He added that the Fed can afford patience if the data cooperates.
We think the September 16 decision will be a close call. We do not expect a hike at this meeting, but the data released over the next week, jobless claims today, payrolls tomorrow, and core CPI on September 11, will drive that outcome more than any single official’s comments.
Structural pressure on yields has not gone away.
Elevated corporate issuance, large and persistent federal budget deficits, and continued uncertainty around inflation are all pushing yields higher, and some of that uncertainty points to the possibility of additional hikes before year end. That pressure is showing up globally, not just in the U.S.
It is also showing up in how the market trades day to day. Kevin Warsh, as the new Fed Chair, has been giving markets essentially no guidance, leaving investors to draw their own conclusions rather than take a cue from him. That vacuum is itself a source of volatility. In this environment, we are seeing investors gravitate toward longer-dated paper yielding above 5% with call protection.
Munis have a cushion, and this week is an early test of it.
Municipal bonds have become cheap enough, with tax-equivalent yields above 7%, to offer some protection from the turbulence the market typically sees in the fall. That cushion, combined with continued fund inflows, has helped the market absorb a record $442 billion of issuance so far this year.
This week’s $14.9 billion new-issue calendar will be an early read on whether that demand holds. The risk is that the cushion narrows if muni-to-Treasury ratios retreat toward their post-tax-reform averages, which would make taxable bonds more competitive just as Treasury volatility and year-end positioning pick up.
Credit quality is improving broadly, though not for every issuer.
Our ratings tracker shows $41.7 billion of upgrades and positive outlooks against $6.9 billion of downgrades and negative outlooks for the two weeks ended August 27. Illinois has been a standout: Moody’s upgraded the state to A1 from A2, affecting $26.4 billion of debt, and separately upgraded Metropolitan Pier and Exposition Authority bonds in Chicago to A3 from Baa1. S&P followed with its own one-notch upgrade of Illinois to A, citing the state’s record of consecutive balanced budgets and reserves it called sufficient to provide adequate protection against a downturn.
We have been buyers of Illinois paper for selected accounts on the strength of that trajectory. Not every credit is moving the same direction: S&P cut San Diego County Water Authority two notches, to AA from AAA on its senior-lien bonds and to AA- from AA+ on its subordinate-lien bonds, a reminder that credit selection still matters even as the broader trend improves. We continue to favor AA-rated paper with strong fundamentals, particularly where it is not insured.
Our Take
Yields are elevated, and last month was a difficult one for anyone sensitive to price swings. Today’s dip on the Fed’s comments is welcome, but we would not mistake it for a turn.
We expect yields to stay volatile through the next two weeks rather than settle. Governor Barr’s warning that inflation risks becoming entrenched sits alongside more encouraging comments from Waller and Williams, and that gap is exactly why we expect the data, not any single Fed official, to set the tone into the September 16 meeting.
We are watching three things closely: how the market reads each data release between now and the Fed meeting, how much, or how little, guidance the Fed continues to offer under its new chair, and whether muni-to-Treasury ratios hold near current levels or retreat toward their historical averages. None of these strike us as reasons for alarm, but they are the variables that could change our thinking, and we are watching them on your behalf.
Our positioning has not changed. We remain buyers at current levels, particularly while yields near 5% are available on longer-dated paper, and we are prepared to act as the data comes in.
Recommendations
Use this week’s data-driven volatility
Jobless claims, nonfarm payrolls, and core CPI will each move yields between now and the September 16 Fed meeting. We see swings in either direction as opportunities for disciplined buyers, not reasons to wait.
Favor higher-grade paper, including select improving credits
AA-rated paper with strong fundamentals, particularly where it is not insured, remains our preference. We have also been buyers of Illinois paper for selected accounts given upgrades from both Moody’s and S&P, though credit selection still matters, as this week’s downgrade of San Diego County Water Authority shows.
Review your taxable-equivalent yield
With tax-equivalent yields above 7%, munis will not match what equities or private equity could return, but they may offer the stability and liquidity many of our clients are looking for as volatility picks up.
Watch the calendar with us
Between now and the September 16 Fed decision, jobless claims, payrolls, and core CPI will shape where yields go next. We are tracking each release and prepared to act on your behalf. 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.
