Why Higher Treasury Rates Are Challenging the Muni Market

We have written many times this year on the support the municipal market has received from the provision in last year’s tax bill that eliminated advanced refunding transactions. Through September, tax-free municipal issuance is down approximately 14% versus the first nine months of 2017. Lower supply is one of the reasons why municipals have produced flat returns through September, while most other investment grade sectors have sold-off with the rise in interest rates.

Of course, this positive technical environment has not just been due to a supply reduction, but also because of steady demand. For much of the year, flows into municipal bond funds has been solid, with net flows (inflows minus redemptions) hovering in slightly positive territory.

This dynamic has changed over the last four weeks. For the first time since late 2016, the muni market has now experienced four straight weeks of net outflows. According to Lipper, flows for the week ended 10/17 were ($636mm), which brought the four-week average to ($495mm).

Unsurprisingly, this has coincided with a rise in Treasury yields. Historically, when US Treasury rates experience a sharp move higher, municipal flows turn negative. Because the municipal market has such a large retail investor base, we tend to see reaction based selling. In other words, when bond prices are selling-off, retail is quick to reduce exposure.

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So far in this redemption cycle, the market has held-in fairly well. We typically assess market health not just on overall performance versus other investment grade sectors, but also on how lower-rated credits are performing relative to higher-rated credits, the subscription levels of new issuance and our anecdotal trading observations. In all three areas, we haven’t seen anything that would cause significant concern. We will be paying close attention in the coming weeks however, not just how the market is trading, but how fund flows are evolving.

Source: JP Morgan, Lipper

Substance in the Age of Spin: IMF Economic Projections

The International Monetary Fund (IMF) is the real deal. It is the global institution whose core mission is to monitor economic activity, policies and financial markets around the world and to offer support to economies in trouble. The IMF is highly capable and credible, and its analysis is data driven.

The IMF, in its semi-annual outlook published last week, is projecting global growth of 3.7% for 2018 and 2019, which is 0.2% lower than the forecast from April. Growth is turning over. The United States is still a bright spot due to extraordinary fiscal stimulus (tax cuts), yet U.S. forecasts are also weakening from 2018 to 2019 due to recently announced trade measures. In the euro area, including the United Kingdom, growth is expected to slow further to below 2%. Growth in many energy exporters has been lifted by higher oil prices, though growth was revised down for Argentina, Brazil, Iran and Turkey, reflecting tighter financial conditions, geopolitical tensions and higher oil import bills. China and a number of other Asian economies are also projected to experience somewhat weaker growth by 2019 due to recently announced trade measures. Notably, China’s growth is projected to slow to 6.2% in 2019 from 6.9% in 2017.

Chart: Real GDP Growth by Country Group (year over year)

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Risks are to the downside in IMF projections due to elevated policy uncertainty, among other factors. Rising trade barriers, a reversal of capital flows to weaker emerging market economies and higher political risk are beginning to slow growth. Also, financial accommodation could tighten rapidly in advanced economies if trade tensions and policy uncertainty expands.

At SNWAM, our base case scenario is similar to the IMF’s, as we are calling for continued yet slowing U.S. economic growth. Risks to growth are increasing, and last week’s stock and bond sell-off is a reminder that it’s best to be cautious; financial markets can turn down well in advance of economic weakness. TV spin economists offer amusing stories and keep us watching, but we will stick with data and analysis from our dull and cautious experts – substance over spin.

Source: IMF World Economic Outlook, October 2018

Higher Oil Prices Are an Increasing Headwind

Oil prices have increased since the lows in early 2016, and the upward trend has intensified since 2017. It is no oil crisis, and we are certainly nowhere near the peak of $145/barrel in June of 2008. Remember filling up your SUV back then?

We care because higher oil prices are yet another headwind to economic growth, a headwind that is getting stronger. Outside of the obvious impacts of higher gas prices and the cost to heat your home in winter, higher oil prices work their way through the economy as petrochemical cost increases and transportation expenses, and eventually end up causing higher inflation. We know the Fed likes to call energy and food price fluctuations transitory, but the flu is also transitory and certainly not pleasant!

Of course, higher oil prices help oil producing countries like Saudi Arabia and Russia. Though the U.S. is certainly producing more oil these days, we are still a net oil importer.

Chart: West Texas Intermediate (WTI) Crude Oil Price

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Unfortunately, on balance higher energy prices are an economic drag and we can see these headwinds increasing. As a basic commodity, oil should settle at the marginal cost of production, which many think is around $65 per barrel. But in the short term it’s all about supply and demand, and for the foreseeable future the concern is about less supply and a continued increase in demand.

There are three major areas of concern around supply. Sanctions imposed on Iran starting in November will reduce supply from this large oil producer, Venezuela production continues to fall rapidly due to political turmoil, and supply growth in the U.S. may be less than expected due to pipeline and technology issues.

Demand growth is still expanding around the world, mirroring strong yet diverging world GDP growth. The U.S. is growing above trend, China’s growth is lower but still likely above 6%, Europe is still positive and Japan, while weak, is still relatively stable.

Continued growth in demand with tighter supplies would not be so big an issue if oil inventories were overflowing and there was plenty of excess production capacity in Saudi Arabia, the world’s swing producer. Alas, this is not the case; Saudi Arabia is already producing at record levels, with less excess capacity after years of lower prices and less investment. So, with supply constrained and demand still growing, the way to bet is for oil prices to go higher.

Time to fill up your gas tank!

Sources: Energy Information Administration, Bloomberg, the Financial Times, International Energy Agency

Third Quarter Review - Ten Years is a Long Time!

This is an important year for bond investors. After ten long years the markets are now offering yields on ultra-safe one year treasuries above the inflation rate, as measured by Personal Consumption Expenditures (PCE). Over the last decade if we wanted to keep up with inflation we needed to take risk longer out on the yield curve or with higher risk bonds. Funds flow data shows investors are attuned to these better yields and are moving funds to short-term high quality bond strategies.

The small downside to rising rates is flat to slightly negative total returns on high quality assets. However, total returns are likely to move closer to current yield levels once the Fed has finished normalizing rates, absent a recession. Market consensus is that the Fed has already completed most of the heavy lifting and there are fewer rate increases ahead of us than behind us.

There is always an argument to hold safe bonds in a portfolio, but now the decision is far easier.

Chart 1: One Year Treasuries Finally Above Inflation

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Index Returns (%) ICE/BAML Intermediate Index Returns (1-10 Yr.)

3Q18 YTD Current Yield to Worst

Treasuries -0.11 -0.75 2.90

Municipals -0.01 0.18 3.47 (1)

Corporates 0.85 -0.77 3.85

(1) Assumes federal tax rate of 32%

Interest Rates

After the late September Federal Open Market Committee (FOMC) meeting the fed funds rate is now targeted to be 2.00-2.25%. This is a large increase from what was close to zero as recently as late 2015. For 2018 it is anticipated we will have 4 rate increases in the fed funds rate, which could make this year the most aggressive period of rate increases during the normalization process. In 2019 the FOMC is projecting the fed funds rate to be a little higher than 3.0%, but the markets are more skeptical and think the Fed will need to dial back on rate increases for a number of potential reasons including slower domestic growth, emerging market weakness, or some other unforeseen event.


Municipals continue to lead returns in 2018 as good technical trends are supporting performance. The 2017 tax reform bill reduced the supply of municipal bonds, as this law eliminated the ability for municipalities to issue advance refunding bonds on a tax-exempt basis. Less supply with steady demand has created a favorable technical backdrop. On top of these good technicals, strong fundamental credit quality adds to the attractiveness of municipals.


This has been a bumpier year for corporates than for municipals. Credit spreads are slightly wider over the course of the year as the market anticipates that corporate earnings are peaking, spreads are historically tight and higher supply due to M&A activity could occur. With spreads slightly wider and overall yields more attractive, we are finding good opportunities in short-maturity corporates that should produce positive returns over treasures even if corporates widen modestly from here.


Our outlook for the rest of the year and into 2019 is similar to what has occurred year-to-date. The Fed is likely to continue raising the fed funds rate, the economy will continue to grow above potential due to still accommodating monetary and fiscal policy, yet domestic and geopolitical headlines will continue to buffer markets and investors will continue to speculate just how much longer this economic cycle has to run. But with short-term yields now above the inflation rate, high quality bonds offer good value and safety.

Sources: ICE/BAML Indices

Why Investors Care so Much About a Few Dots

The Federal Reserve Open Market Committee (FOMC) is set to meet this week and is widely expected to announce a 0.25% increase in the Federal Funds Rate (FFR). This would mark the third increase of 2018 and bring the targeted range for the FFR to 2.0-2.25%. With this action fully priced into the market, all eyes will be on the Fed’s forward guidance, particularly the committee’s expectation for the FFR in 2019. The most recent expectation from the Fed is for one more increase this year, and another three next year, which would bring the FFR above 3%. Individual committee member rate expectations are represented as dots on the below chart, which makes these dots the main attraction for many investors.

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So why does this matter so much? With the economy humming along nicely this year and inflation well contained around the Fed’s target level of 2%, the FOMC appears to be using this opportunity to bring the Fed Funds Rate to a normal level, after being at the zero bond for years post the financial crisis. This action does not come without consequences, however. In recent weeks we have seen a spike in volatility in emerging markets, which many market participants are ascribing to the tightening of monetary policy by the Fed. The economic boost that fiscal stimulus has brought will also begin to wind down in 2019. And don’t forget the yield curve, which has flattened to very low levels. Another four hikes in the next 15 months would likely cause the curve to invert, which has historically preceded a recession.

So don’t worry about the headlines detailing the 25bps hike in the Fed Funds Rate. Watch the dots, as that forward guidance will be what investors care most about.

Source: Federal Reserve