The Week in Muniland

The muni market has started out the new year strong with the Bloomberg Municipal Bond Index (the Index) up 0.73%. This follows a weaker than expected December that was down 0.33%.

• Why it matters: Last year was marked by a volatile ride in the muni market with record new issuance and the threat of municipal tax exemption being curtailed, which presented a significant headwind through the first half of the year. However, a significant tailwind during September through November resulted in the Index being up 4.25% for the full year. As we roll into 2026, we expect both headwinds and tailwinds, since performance never moves in a straight line. Nevertheless, with high yields, a steep yield curve and a bias toward additional fed rate cuts as the US economy slows, we anticipate munis to post another year of positive performance. Our 2026 muni outlook, High After-Tax Yields in an Uncertain World, provides additional insights into the drivers of 2026 performance.

The US economy added 50,000 jobs in December, lower than the previous month and lower than expected, and there were downward revisions to hiring data for both October and November. The unemployment rate, however, fell by a tenth to 4.4%.

• Why it matters: On net we think that the data doesn’t really change the fundamental picture. The labor market is stagnant but not collapsing, and we expect that will be sufficient for the Fed to pause in January and await more information rather than continuing to cut rates. We do get inflation data next week that could impact its thinking, but the Fed told us in December that its expectation is for a pause in January, and we expect it to deliver that outcome. For the January 28 meeting, markets have priced in 2 basis points of cuts, which equates to an 8% probability of a 25-basis-point reduction. Looking ahead, the next full 25-basis-point rate cut is anticipated for the June 17, 2026, FOMC meeting. In total, 53 basis points of cumulative cuts are expected between now and the end of 2026, with the terminal rate currently trading at 3.11%.

We have received many questions regarding the alleged fraud in Minnesota and California, and its subsequent effects on the municipal market. We anticipate this is only the start of what will be a rocky year in terms of political headlines, given the upcoming midterm election cycle.

• Why it matters: Minnesota has more than sufficient liquidity to withstand an estimated $2 billion cut in federal aid, which is 3% of the state’s budget. The state’s rainy day fund is projected to reach $3.5 billion, providing a solid financial safety net. In addition, a budget surplus of $2.5 billion is expected, further strengthening the state’s fiscal position. Minnesota is well prepared to address any challenges that may arise, making spending cuts increasingly unlikely and ensuring continued stability. The State of California has $115 billion in cash reserves and $87 billion in additional liquidity, which makes a $2 billion reduction in federal aid inconsequential. The five democrat-led states that had their federal childcare and family assistance funds frozen have already filed a lawsuit and will likely be successful. For context, the broad freeze in federal funding in January of 2025 was rescinded in a week, and agencies were ordered to resume normal disbursements.