Bonds

Munis sell off after Fed indicates rates will be higher for longer

Munis sold off Thursday, joining bond markets and equities in a rout after the Fed signaled that interest rates would be higher for longer.

The Federal Open Market Committee held rates steady Wednesday, as expected, but signaled another hike this year.

Munis were steady Wednesday but triple-A yields were cut eight to 16 basis points Thursday, depending on the scale, following along with U.S. Treasuries which saw the largest losses out long.

Ratios rose. The two-year muni-to-Treasury ratio Thursday was at 65%, the three-year was at 66%, the five-year at 67%, the 10-year at 71% and the 30-year at 89%, according to Refinitiv MMD’s 3 p.m. read. ICE Data Services had the two-year at 65%, the three-year at 67%, the five-year at 67%, the 10-year at 72% and the 30-year at 93% at 4 p.m.

Coming into the September FOMC meeting, the market was “biased lower,” said Pat Luby, a CreditSights strategist.

“A lot of the market had been looking forward to hopefully hearing that the Fed was closer to cutting rates, not farther away from cutting rates,” he said. “So the extension of the pause and the clear potential that the Fed is going to want to raise rates pushes out a potential rally in bond prices.”

He said the market needs to “readjust their inflation expectations and the Fed expectations.”

“We’re in a time of the year when the market was already weak and facing the prospect of an increase in supply, seasonal weakness,” he said. “There’s a number of factors coming together.”

Jeff MacDonald, head of Fixed Income Strategies at Fiduciary Trust International, noted he “would expect munis to follow taxable rates higher here.” “We’re in the process now of making that transition,” he said.

The general bias toward muni rates is that they would rise with technicals “being a little less supportive than they were in August, plus what we heard with from the Fed … ‘higher for longer,’ and potentially another hike,” he said.

He said the Fed is nearing the end of its tightening cycle but there has yet to be confirmation.

“Technicals in the muni market and the initial move by taxable rates should lead to an upward bias to yields in here,” he said.

Municipal mutual fund outflows continued Thursday, however, high-yield funds and exchange-traded funds saw inflows. Refinitiv Lipper reported $27.444 million was pulled from municipal bond mutual funds for the week ending Wednesday after $116.737 million of outflows from the funds the previous week. High-yield muni funds reported inflows of $85.488 million versus outflows of $11.381 million the week prior. Exchange-traded muni funds reported inflows of $525.396 million versus $1.011 billion of inflows in the previous week.

While there are opportunities in the muni market, outflows are complicating them, said Lawrence Gillum, chief fixed income strategist for LPL Financial.

“Investors should be moving back into the muni space, given the yields that we’re seeing in a lot of these markets,” he said. “But performance last year, and part of this year has just been pretty negative, so it’s understandable so that some investors are just kind of throwing in the towel.”

MacDonald said, “the trend that’s been in place is the opening mutual funds, getting hit with outflows, and the ETF market being a beneficiary of some of those outflows when investors want to come back,” he said.

While supply was light in the summer, issuance is set to pick up in the coming months, Gillum said.

“This is the time of the year where you start to see additional supply from the market after the summer doldrums where there’s not a lot of supply,” he said. “There’s some decent reinvestment back into the markets.”

However, “we’re getting into that seasonal period, where the next couple of months could be potentially tough from a supply-demand perspective,” Gillum said.

On the plus side, this could be another good opportunity to add duration to a muni portfolio.

There is also “an attractiveness on an after-tax basis for munis for high-tax investors,” MacDonald added.

Market fundamentals are strong, he said.

Rainy day funds are in good shape, and while revenues may be softening a little bit, fundamentally, state and local governments are also in good shape, MacDonald noted.

Rates are higher and borrowing is more expensive, so he said the desire to borrow at these rates is most likely on the weaker side.

There could be a bit of a pickup in supply, but seasonally, he said the need to borrow is lower than it’s been the past few years, according to MacDonald.

Rates, he added, may temper some of the issuance.

However, Gillum said, “we’re probably past peak fundamentals.”

“We were in this period where there was a lot of pretty solid balance sheets … but those days are probably behind us,” he said.

However, Gillum said there are still a lot of strong fundamental credits out there that shouldn’t have any sort of challenge.

Muni CUSIP requests rise
Municipal CUSIP request volume rose in August on a year-over-year basis, following an increase in June, according to CUSIP Global Services.

For muni bonds specifically, there was an increase of 33% month-over-month and a 14% decrease year-over-year.

The aggregate total of identifier requests for new municipal securities, including municipal bonds, long-term and short-term notes, and commercial paper, rose 25.7% versus July totals. On a year-over-year basis, overall municipal volumes were down 11.4%. CUSIP requests are an indicator of future issuance.

Secondary trading
California 5s of 2024 at 3.36%-3.28%. Utah 5s of 2024 at 3.42% versus 3.33% Tuesday. Connecticut 5s of 2025 at 3.47% versus 3.34% Monday.

Virginia 4s of 2028 at 3.19%. LA DWP 5s of 2029 at 2.92%. Washington 5s of 2030 at 3.25%-3.24%.

DASNY 5s of 2033 at 3.08%. California 5s of 2034 at 3.30% versus 3.19% Tuesday and 3.15% on 9/13. NYC TFA 5s of 2034 at 3.53%-3.52%.

Washington 5s of 2048 at 4.33% versus 4.18%-4.16% on 9/12 and 4.27%-4.20% on 9/7. Triborough Bridge and Tunnel Authority 5s of 2048 at 4.55%-4.35% versus 4.31%-4.30% on 9/8. Massachusetts 5s of 2052 at 4.36% versus 4.18%-4.15% on 9/8.

AAA scales
Refinitiv MMD’s scale was cut 10 to 12 basis points: The one-year was at 3.42% (+12) and 3.32% (+12) in two years. The five-year was at 3.10% (+12), the 10-year at 3.16% (+12) and the 30-year at 4.07% (+10) at 3 p.m.

The ICE AAA yield curve was cut eight to 12 basis points: 3.43% (+8) in 2024 and 3.36% (+10) in 2025. The five-year was at 3.10% (+12), the 10-year was at 3.12% (+12) and the 30-year was at 4.10% (+11) at 4 p.m.

The S&P Global Market Intelligence (formerly IHS Markit) municipal curve was cut 10 to 12 basis points: 3.43% (+12) in 2024 and 3.32% (+12) in 2025. The five-year was at 3.11% (+12), the 10-year was at 3.16% (+12) and the 30-year yield was at 4.07% (+10), according to a 3 p.m. read.

Bloomberg BVAL was cut 10 to 16 basis points: 3.39% (+10) in 2024 and 3.32% (+12) in 2025. The five-year at 3.04% (+10), the 10-year at 3.13% (+15) and the 30-year at 4.10% (+15) at 4 p.m.

Treasuries sold off.

The two-year UST was yielding 5.143% (-2), the three-year was at 4.854% (+2), the five-year at 4.617% (+7), the 10-year at 4.485% (+12), the 20-year at 4.758% (+16) and the 30-year Treasury was yielding 4.562% (+15) near the close.

FOMC redux
The FOMC held rates steady Wednesday, marking the second time the Fed has kept interest rates unchanged since it began its tightening cycle last year.

“[Wednesday’s] hawkish pause should have surprised no one,” said Christian Hoffmann, portfolio manager at Thornburg Investment Management. “Pre-announcement, the market priced in roughly a 1-in-a-100 chance of a September hike.”

Furthermore, he said “those looking for Powell to tone down the ‘hawkish pause’ were likely disappointed, with equities selling off about 15 minutes into the press conference, the yield curve inverting further, and the two-year Treasury note setting new highs.”

“As always, the FOMC event provided a mixed picture overall, and no one should be too certain about the future in this unusual age, but perhaps the most indicative market reaction was that because the dot plot was more hawkish than expected, the Fed Funds futures’ implied December 2024 rate increased 13 basis points, about half of a hike, just before an odd move right on the close,” said John Vail, chief global strategist at Nikko Asset Management.

The Fed is “very cognizant of the risks involved in waving the all-clear flag on rates too early; this would likely result in a further rally in risk assets, and further easing financial conditions, sooner than it would deem appropriate,” said William Blair macro analyst Richard de Chazal.

Powell’s goal “was therefore to continue to keep the market guessing, keep all the Fed’s options firmly on the table, and leave the door fully open to the possibility of a further rate increase possibly later this year,” he said.

A majority of participants still see at least one more rate hike this year.

This may be because “monetary policy may not yet be restrictive enough to achieve the Fed’s inflation objectives, said the Payden & Rygel economics team.

The team noted “a lot depends on the elusive, unobservable neutral rate.”

Over the long run, the team said “participants think the neutral nominal fed funds rate is 2.50%, meaning a 5.50% federal funds rate target is well into restrictive territory.”

But as Powell said at the post-FOMC meeting press conference, “You know sufficiently restrictive only when you see it, not in a model,” according to the Payden & Rygel economics team.

Powell later added: “It is certainly possible that the neutral rate at this moment is higher than that [higher than 2.50%].”

Either way, both the market and the Fed appear to agree “that we are at or near the end of the hiking cycle,” Hoffmann said. However, there is still debate about the duration of time that rates will remain elevated, he said.

As the market had expected the Fed to hold rates steady, “the bigger story lay in the Fed’s updated Summary of Economic Projections, which included substantial upward revisions to the path of real GDP, downward revisions to the unemployment rate, and significant upward revisions to estimates of the policy rate at year-end 2024 and 2025, said Mickey Levy, chief economist for Americas and Asia at Berenberg Capital Markets and a member of the Shadow Open Market Committee.

The wholesale changes to the September SEP is “a departure from the Fed’s projections made in June, and while Chair Powell denied it in his post-meeting press conference, the September SEP suggests most Fed members now view a ‘soft’ or ‘no’ landing as their baseline economic scenario,” he said.

Levy noted “the extraordinary widening of the dispersion of dots for 2025 and 2026.”

“Obviously, there is a wide array of views among FOMC members about the most appropriate policy rate for achieving healthy economic growth and lower inflation,” he said. “One would think such a wide dispersion would result in a lot of dissent on policy decisions, but don’t count on it. It’s too bad we cannot link each dot with the individual FOMC member’s economic and inflation projections.”

While the “median Fed member continues to forecast a longer-run policy rate of 2.5%, there are now seven members with projections above the median, up from four members in the March SEP,” he said.

Mutual fund details
Refinitiv Lipper reported $27.444 million of outflows from municipal bond mutual funds in the week ending Wednesday following $116.737 million of outflows the week prior.

Exchange-traded muni funds reported inflows of $525.396 million versus $1.011 billion of inflows in the previous week. Ex-ETFs muni funds saw outflows of $552.840 million after $1.128 billion of outflows in the prior week.

Long-term muni bond funds had $336.748 million of inflows in the latest week after inflows of $68.356 million in the previous week. Intermediate-term funds had $75.353 million of outflows after $29.521 million of outflows in the prior week.

National funds had outflows of $58.457 million versus $35.791 million of outflows the previous week while high-yield muni funds reported inflows of $85.488 million versus outflows of $11.381 million the week prior.

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