Following a year in which the Federal Reserve hiked rates four times, it may be somewhat surprising that market analysts are now pricing in a rate cut – potentially several of them. Closing out the first half of the year, stock indexes reached new highs with the best June on record in 50 years, while U.S. Treasury and municipal interest rates dropped to four-year lows. To help provide insight on this and other factors that may affect the muni market going forward, we spoke with Baird Senior Fixed Income Analysts Craig Elder and Dave Violette for their perspective.
Baird: Let’s start with the Fed. On June 19, the Federal Reserve announced they weren’t moving rates up or down, and the S&P responded by setting new all-time highs. What’s going on?
Craig: After four rate hikes in 2018, the Fed essentially took a moment to catch its breath in June and take stock of where we are. The market seemed especially responsive to Fed Chair Jerome Powell’s choice of words in explaining their decision to hold rates steady. A few months ago, the Fed said they will be “patient” as they considered rate adjustments. In June’s FOMC statement, they removed “patient” and said they will “act as appropriate.” That’s been widely interpreted as foreshadowing a rate cut at the July meeting with up to two more this year, bringing the Fed target rate to the 1.75–2.00% range last seen a year ago. (See the FOMC participants' assessments of appropriate monetary policy: Midpoint of target range or target level for the federal funds rate.)
As of the end of June, according to Fed Futures on Bloomberg, 100% of market participants believed the Fed will cut rates at their July Fed meeting – a markedly different tone than in November, where the chances of a hike were at 80%. And any positive economic releases or news as it relates to trade negotiations can change the tone. For instance, after the better-than-anticipated June jobs report, which was released the first week of July, market participants took the possibility of a 0.50% rate cut completely off the table. I believe that the Fed will likely do one 0.25% cut in July, one in September and possibly an insurance cut in December, keeping rates put for 2020 to try to remove themselves from the politics that come with a presidential election.
Baird: How do rate hikes and rate cuts affect the municipal market?
Dave: If you’re an investor, you generally like to see the Fed raise rates as, at least in the short term: Treasury rates tend to follow the Fed’s and munis typically follow Treasurys, though at a slower pace. The higher the interest rates, the more interest earned for investors. A rate cut is vice-versa: It benefits issuers as it becomes less expensive to issue debt – that is on the short end of the curve. With the expectation of a rate cut in July and potentially additional rate cuts later in 2019, this could turn out to be a good time for issuers to go to market.
Craig: To put some numbers behind what Dave is saying, at the conclusion of their two-day meeting on June 20, the two- and five-year U.S. Treasury yields declined 14 and 11 basis points respectively compared to the beginning of the week, while the 10- and 30-year only dropped 5 basis points. Munis followed but not as drastically, with the two- and five-year declining 5 basis points and the 10- and 30-year yields declining only 3 basis points. With more rate cuts on the horizon, the short end of the curve is likely to continue to decline. If you compare municipal interest rates on July 5 to those from the end of last year, you’ll see on average a 68 basis-point decline across the curve. And with more rate cuts on the horizon, the short end of the curve is likely to continue to drop.
Baird: So let’s talk about that volatility. What’s behind the Fed changing course?
Craig: We’re in the longest economic growth cycle in U.S. history, but at this time there’s a lot of uncertainty around how sustainable it is. For every report about the strong U.S. labor market, there’s another on excess inventory stemming from trade wars with China. For every announcement that inflation is near its target level, you see another on the effects of tariffs on the larger economy, or the slowdown of the global economy. With all that’s going on with the economic data, it’s worth remembering that multiple rate cuts typically suggest the economy is facing distress and could benefit from some sort of monetary support.
Baird: Is there a chance the Fed will continue to wait-and-see at July’s meeting?
Craig: According to Fed Funds future, the July rate cut is a 100% certainty. Personally, I don’t think even June’s stronger-than-anticipated jobs report will keep the Fed from cutting rates in July, but it could impact how many rate cuts we have and their timing. Reaching a trade deal with China could move the needle some too.
Baird: At the end of 2018, we talked about the yield curve and how its inversion could indicate a coming recession. We saw that inversion happen in late June, when investors were receiving 0.12% more in yield owning a three-month Treasury (2.12%) than a 10-year Treasury (2.00%). Yet talks about recession seem to have subsided somewhat.
Dave: That’s right. Part of that goes back to what Craig was saying, that there’s enough positive economic news to tame fears over a recession, at least in the short term. Our colleagues Willie Delwiche and Bruce Bittles pointed out a recent Wall Street Journal poll in which only 4.9% of economists surveyed believe the economy will slip into recession this year. About half expect a recession in 2020 and 37% are expecting a recession in 2021. Their point being, the combination of low interest rates supported by the Federal Reserve, global central banks willing to sustain the economic expansion and unemployment at historic lows will fuel consumer spending, pointing to the upside to the stock market.
Also, an inverted yield curve is not really a reliable indicator for a recession. For example, if you compare the 10-year Treasury with the two-year Treasury, or the 30-year Treasury with the five-year Treasury, you’ll see the yield curve has actually been steepening for the past six and 12 months, respectively. So take what yield curves have to say about the broader economy with a sizable grain of salt.
Baird: Moving away from the Fed, what do you expect for the muni market for the rest of 2019?
Dave: Municipal bonds are in strong demand, for a couple of reasons. One, central banks around the world are offering 0% or even negative yield, making both Treasurys and municipal bonds attractive both domestically and abroad.
Also, with new caps on state and local tax, or SALT, deductions as a result of tax reform, this makes municipals even more attractive to those in high-tax states.
Craig: Speaking of tax reform and buyers, we are seeing stronger interest from retail buyers. With minimal changes to tax brackets for individuals compared to corporate investors combined with caps on SALT deductions, retail has strengthened over the past year, and thanks to lower ratios on the long end of the curve, investors are willing to take on duration. According to the Federal Reserve, comparing the end of 2017 (prior to tax reform law going into effect) to the first quarter of 2019, individuals and mutual funds increased their holdings in municipal bonds by $20.5 billion and $58.4 billion, respectively, while banks and insurance companies decreased their holdings by $91.6 billion and $43.5 billion, respectively.
Dave: Lastly, and probably most importantly, supply continues to remain low as a result of tax law changes and the loss of the ability to advance refund on a tax-exempt basis. Issuance is up minimally compared to this time last year and is still more than 21% and 35% lower than 2017’s and 2016’s first-half volume, respectively. And with investors gaining their principal back due to bonds maturing or being redeemed, municipal investors have a lack of supply to reinvest. Furthermore, according to the Investment Company Institute, we’ve had approximately 25 weeks of positive municipal bond inflows with an average of $1.7 billion per week through the first half of 2019, which is another indicator of demand.
Going forward, the summer months tend to be lighter months, so we’d expect supply to weaken but demand to stay intact. Otherwise, all eyes are on the Fed and how they’re interpreting broader economic events.
For the latest views into what’s moving the municipal market, be sure to check out our Fixed Income News and Insights page.
Investors should consider the investment objectives, risks, charges and expenses of each fund carefully before investing. This and other information is found in the prospectus and summary prospectus. For a prospectus or summary prospectus, contact Baird directly at 866-442-2473 or contact your Financial Advisor. Some of the potential risks associated with fixed income investments include call risk, reinvestment risk, default risk and inflation risk. Additionally, it is important that an investor is familiar with the inverse relationship between a bond’s price and its yield. Bond prices will fall as interest rates rise and vice versa. Municipal securities investments are not appropriate for all investors, especially those taxed at lower rates.