The Week in Muniland

The municipal market continued its impressive rally this week, with long-maturity bonds materially outperforming shorter-maturity bonds. The Bloomberg Municipal Bond Index (the Index) returned 1.48% and is now up 2.38% month to date. The year-to-date return is now 2.70%.

• Why it matters: The rally in longer-maturity bonds has been impressive but not surprising. It was only a matter of time until the bonds that were extremely cheap (Display 3) would outperform shorter-maturity bonds. It was also just a matter of time before the obscenely steep municipal yield curve (Display 1) would begin to flatten. The question was never if, but rather when. Month-to-date the Bloomberg 20-year Maturity Index is up 3.64%, while the Bloomberg 22+ Maturity Index is up 3.98%. Over the same period, the Bloomberg 5-year Maturity Index is up 0.95%. It’s our expectation that longer-maturity bonds will continue to outperform shorter-maturity bonds given they remain cheap relative to US Treasuries and the curve remains abnormally steep.
  
  

One question we’ve been getting is, since bonds have rallied so much this month, is it too late to invest? The answer is an emphatic no!

• Why it matters: The fact that the slope of the municipal yield curve remains extremely steep and long bonds are cheap relative to US Treasuries (UST) indicates that long muni bonds have a long way to go until they are considered fair value. Short-maturity bonds have clearly become expensive as significant investor demand has driven those yields lower. In fact, shorter muni bonds have become so expensive, we recommend that investors, when able, consider owning shorter USTs in place of shorter high-grade municipals, since on an after-tax yield basis they will earn more on the UST (see two-year bond in Display 3). For some perspective, if yields fall just 50 basis points over the next 12 months, the five-year and 20-year indices would return approximately 4.4% and 9.2%, respectively (Display 2). However, given the expensiveness of the short end of the yield curve and the cheapness in the long end, it’s more likely long bond yields will fall more than short bond yields. Next week brings a very light new issue bond calendar, at only $6 billion, coupled with modest September 15 reinvestment cash hitting the market—a positive technical tailwind. The light calendar is due to the Fed meeting at which they will most likely cut rates by 25 bps—an outcome the market is fully pricing in. The near-term future for bonds remains bright. It’s not too late, but it is time to get off the sidelines.

The US Consumer Price Index (CPI) for August was in line with expectations. Core CPI rose 0.3% month over month and is now up 3.1% year over year.

• Why it matters: The underlying details of the inflation data do not suggest convergence to the Fed’s target over a reasonable forecast horizon. Core inflation is not annualizing close to 2%, and the most recent prints reflect an acceleration rather than a deceleration. Not only that, but the pressure on prices is not limited to tariffs; services inflation has picked back up as well. Nonetheless, we expect the Fed to cut rates by 25 bps next week. Why? Risk management. While price pressures are not coming down, neither are they rising in a way that seems disruptive. At the same time, the balance of risks around the labor market has clearly deteriorated. With the Fed funds target rate above neutral, meaning that it is restraining economic activity, we believe the Fed will respond to the greater threat, which is the labor market. Therefore, we continue to believe they will cut rates at each of their three remaining meetings this year, even with inflation above target.