2018 Midyear Fixed Income Market Outlook
July 2018
Rising interest rates, a revamped tax structure, the potential for a massive trade war, strong economic numbers and volatility in the stock market have made for a noteworthy year in fixed income thus far. We spoke with Senior Fixed Income Analysts Craig Elder and Dave Violette on what to expect from the muni market for the remainder of 2018.
The Tax Cuts and Jobs Act | |
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Baird: When you talk about the first half of 2018, you have to talk about the Tax Cuts and Jobs Act. What impact has tax reform had on munis?Dave: The new law also significantly lowered tax rates for individuals and corporations. If you’re an investor in a higher tax bracket, the fact that muni bonds were tax-free provided a compelling risk/reward. Now that tax rates have been lowered across the board, there’s less urgency to find investments that have those added tax benefits. It made the muni bond–corporate bond comparison a little tighter. Craig: When looking at Federal Reserve data, what stands out is that bank holdings of municipal bonds are down by $15.8 billion from the fourth quarter of 2017 to the first quarter of 2018. As a side note, the data also indicates that the shift in ownership by individual households is away from individual bonds (down more than $44 billion in the past year). However, they have not left the municipal market, as they have instead purchased them through mutual bonds and ETFs (up more than $46 billion). Baird: Is there still a demand for munis?Dave: Craig: |
A Flattening Yield Curve | |
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Baird: Beyond tax reform, what other factors are impacting the municipal market right now?Dave: So when the curve rises on the short end and doesn’t keep pace on the long end, you get what’s known as a flattened yield curve, which we have experienced for most of 2018. In fact, in the first week of July, the yield spread between the 2-year and 10-year Treasury note fell to the lowest level since 2007. When short-term rates become higher than longer-term rates, the yield curve begins to invert. Baird: Isn’t a flat or inverted yield curve an indicator of a recession?Dave: |
Federal Reserve and Rate Hikes | |
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Baird: As expected, the Fed has raised rates two times this year after their March and June meeting attributing the hikes to stronger employment numbers, stronger economic numbers and inflation nearing its target rate. How many more rate increases do you anticipate this year?Dave: The Fed’s stated goals are full employment and price containment, or maintaining inflation. They certainly have achieved their goal for employment, and inflation is slowly moving toward their inflation goal as well. Craig: Dave: Baird: So, as an investor, how would you prepare for the possibility of the yield curve inverting?Dave: My advice would be to stay high in quality and at least think about reducing higher-risk exposures. Craig: |
Tariffs and Trade Wars | |
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Baird: You mentioned tariffs and trade wars. How could they influence the muni market?Dave: Craig: Ultimately, slow economic growth is good for bonds and inflation is bad for bonds. In times of economic distress, though, investors often turn to bonds for shelter. Dave: |
Outlook for 2018 and Beyond | |
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Baird: What are you watching for going forward?Craig: Dave: |