It was a very tough third quarter for the bond markets in general and for the muni market in particular.
The table below lays out the quarter.
The change in muni yields followed the increases in Treasury yields during the quarter, with greater increases in the front end of the yield curve. This was an area where we thought short-term munis were most overpriced on a yield basis compared to Treasuries. In many general market states with low tax rates, it made more sense to own a Treasury and pay the federal tax than to own the municipal bond equivalent. This is starting to correct.
What was the cause? Really, a combination of factors – nothing by itself. We have had jobless claims running below expectations for much of the quarter. In the 12 weeks since June 30th, jobless claims fell below expectations seven times, were in line three times, and were higher once.
Trailing headline inflation has fallen since the May numbers, from 4.0% to 3.7%. But recent monthly numbers have been higher than in previous months (though not higher than forecast) because of the surge in energy prices. Trailing CORE CPI (ex food and energy) has fallen since the May numbers, from 5.3% to 4.3%.
The PCD deflator has been at the 0.2% monthly level.
Housing starts have continued to decline.
We can go on with other economic indicators, but the real reason that rates have risen is FEAR OF THE FED.
The Federal Reserve raised the short-term fed funds band to 5.25–5.50% at its July meeting. There was no August meeting, and at the September meeting they paused but with a very hawkish tone, from both Chairman Powell and other Fed governors. The mantra was that short rates would stay HIGHER for LONGER. In other words, do not look for a cut anytime soon. This message changed the dynamics of the bond market. And a 10-year Treasury bond yield, which rose 37 basis points over two months from June 30th to August 31st, has risen 45 basis points since the beginning of September. Ten-year AAA muni yields also rose during September by 38 basis points, after rising 40 basis points in the first two months of the quarter – not so much from bond fund liquidations (which have been modest compared to last year’s outflow numbers) as from underwriters, fearful of the market, selling new issues extremely cheaply, and thus scales being cut.
What does this rise in rates mean?
The chart below shows the 10-year Treasury yield, the 10-year TIPS (inflation-adjusted Treasury) REAL yield, and the 10-year breakeven inflation rate, which is the difference between a nominal 10-year yield and the REAL yield on TIPS. You can see that the REAL yield on TIPS is now at the inflation expectations rate. In other words, REAL YIELDS are starting to BITE.
Auto loan delinquencies are starting to rise.
Credit card debt continues to rise, and the interest component of this debt also rises.
The QUITS rate in the job market has been falling.
Various regional Federal Reserve business indicators continue to trend into negative territory.
Regional banks are caught in the crosshairs of higher deposit rates (if they are paying them) and lower book yields on their bond portfolios bought in 2021. Also, there is an overhang of office property loans that need to be rolled over, but a lot of these properties are worth 50% or less than they were a few years ago. (The Wall Street Journal has been publishing on this.)
Student loan debt starts to be paid back.
There is a looming auto strike.
We have a potential government shutdown.
We think that the muni market, on the back of the Treasury market, got cheap again, much as it did last fall in late October/early November, though not as high in yield, as the bond fund outflows are less onerous.
The chart below shows the various yield curves plus the TAXABLE equivalent yield of tax-free bonds. Clearly, many bonds are at higher yields than this, and the taxable equivalent yields of bonds from high-tax states are even higher. Double exempt bond yields at 4.5% or higher in high-income-tax states like New York, New Jersey, and California have a taxable equivalent yield of 9% – extremely competitive with long-term equity returns.
Though the latest run-up in Treasury yields has been painful for markets, the continuing tightening of financial conditions and inflation’s trending lower and slowing economic performance will make today’s levels look attractive by next year.
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