The tax-free municipal bond market has staged one of the best comebacks since Lazarus over the past month. We have seen a dramatic improvement in the market, with bond yields dropping substantially across the entire curve. The graph below shows the AA municipal yield curves on 10/19 and 11/16.
How did yields get so high?
With regard to munis, the backdrop of higher Treasury rates (hitting 5% on the 10-year in mid-October) certainly made municipal bond underwriters squeamish in the pricing of deals. Below is a graph of Bond Buyer Visible Supply, and you can see the gigantic bulge in supply last month. Dealers (who did not wish to have unsold balances) priced bonds very cheaply, with many high-grade names priced below 5%. This had the effect of evaluation services using some of this outlier pricing to REPRICE the entire secondary market of munis, and thus month-end prices for October were down more than the market would have suggested. Since then, the supply bulge has retreated, allowing munis to be more properly priced to Treasuries.
What helped turn the muni market around?
The last Fed meeting, in October, included another pause, keeping fed funds in the 5.25–5.50% range. But unlike the “high for longer” mantra that had spooked the bond markets at the Fed meeting in September, this meeting included comments that the Fed had seen signs of moderating in the economy. In addition, the October jobs numbers showed payroll gains of 150k versus expectations of 180k, and unemployment ticked up to 3.9% from 3.8%. To the bond community, moderating = slowdown, and rates continued to move lower, with the 10-year piercing the 4.5% level this week.
Slowing inflation continues to help the bond market.
Both the Consumer Price Index and the Producer Price Index numbers this week were bond-friendly, with the headline CPI monthly number at 0% and the headline PPI monthly at -0.5%. This reflects a lot of anecdotal evidence we have seen, whether it is dropping energy prices, lower shipping prices, or reductions in air fares, just to cite some examples.
The graph below shows both the CPI and PPI year-over-year numbers going back to pre-Covid. We can see the large increases in the Producer Price Index in the first part of last year, reflecting the supply chain crunches, but moderation since then. The relationship between CPI and PPI is complex and two-way, but our belief is that over time PPI does tend to lead CPI, though with a time lag.
The muni market has gone through a number of these selloffs in the past 15 years. Below is a graph that we have shown a few times, “Muni Market Feast and Famine.” Below that we have the chart of the Bond Buyer 40 yield to maturity. You can see the moonshot of yields that came with the supply bulge buttressed by the harsher Fed language and giveaway deals by dealers. The turnaround is a few weeks has been dramatic.
Will the rally last?
The technicals for the muni market tend to be good as we head to year-end, as December and January have the largest bulge of coupon payments, maturing bonds, and called bonds. At what are still attractive 4.25–4.50% yields (6.75–7.15% taxable equivalent yields for the highest federal bracket, NOT counting any state taxes, which would boost a double-exempt bond higher), we think the bond market, which could use some stability, may have some for a while.
Happy Thanksgiving!
John R. Mousseau, CFA
Chief Executive Officer & Director of Fixed Income
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