More Myth Debunking

April 2017

Fed lifting short-term interest rates; don’t expect long-term rates to respond

  • Positive municipal market performance continues
  • Market technical trend remains supportive; demand strong and supply drops
  • States reduce debt borrowing in light of declining tax collections
  • Fed lifting short-term interest rates; don’t expect long-term rates to respond

Municipal market price momentum is encouraging. The Bloomberg Barclays Municipal Bond Index gained an additional 0.73% in April, bringing its year-to-date gain to 2.32%. Following November’s post-Trump election sell-off, the Index has posted five consecutive monthly gains totaling 3.73%, which has just about recouped the late 2016 loss.

chart 1

The Municipal market’s year-to-date performance can be attributed to consistent investor demand and lower supply. Investors will receive over $15 billion from tax-exempt bond coupon payments in May, while net bond issuance should only be about $8.6 billion. Demand has outstripped supply as municipal issuers are reluctant to incur more debt in light of existing pension and retiree healthcare obligations. State and local governments are expected to continue to follow along the reduced issuance path and market fewer new municipal security issues over the balance of the year.

According to a recently released study from the Nelson A. Rockefeller Institute of Government, the median forecast for state income tax growth for the end of the current fiscal year (June for most states) was lowered to 3.6% from 4.0%. Furthermore, the forecast for sales tax collections was cut by 26%, to 3.1% from 4.2%. If these projections come to fruition, states and local governments will have less to spend on public projects, schools, and infrastructure. The Institute highlighted the difficult choices that might have to be made, including the unpopular options of raising taxes, tapping limited reserve funds, or reducing spending and borrowing. Less new municipal debt issuance will likely persist.

We expect the Fed to continue with its interest rate normalization process with two additional rate hikes this year and to begin liquidating its large portfolio of Treasury securities. However, if the economic data begins to sour, Fed Chair Yellen might have to proceed with greater caution by reducing the number of short-term rate hikes currently contemplated.

In last month’s Commentary, we attempted to debunk the "market timing" myth and presented evidence that showed investors actually lose valuable tax-exempt income by not maintaining a fully invested bond posture. This month we challenge the veracity of another widely held market myth:

"Fed short-term interest rate tightening results in equivalent higher long-term interest rates"

Many investors mistakenly assume that short-term and long-term interest rate movements are linked through comparable yield movements. However, history disproves this notion. Currently, the Fed is in the early stages of attempting to "normalize" short-term interest rates through periodic bumps to the Federal Funds rate, but long-term interest rates are not responding. In December 2015, the Federal Reserve embarked on a systematic program to move the inter-bank overnight lending (Federal Funds) rate from near 0% to its current rate of approximately 1%. The benchmark 10-year U.S. Treasury bond still yields approximately 2.28%, essentially unchanged from the time the Fed’s program commenced. Further short-term rate hikes are likely over the balance of the year. SMC FIM does not anticipate a significant change in longer- term rates (i.e., greater than ten years in maturity), and we believe a case could be made for a move lower before the end of 2017.

During the last extended period of Fed rate tightening (2004-06), the Federal Funds rate increased by 425 basis points; however, the 10-year U.S. Treasury yield only experienced a 50 basis point increase. During this time period, municipal bond yields, as measured by the Bond Buyer 20-Bond MunicipalvBond index, actually declined by 27 basis points. Historically, the movement in tax-exempt bond yields generally fails to match that of Treasury or comparable corporate securities.

We believe there is a good chance that history will repeat itself during the current phase of shortterm rate increases. Why? First, think about what long-term interest rates reflect: the expectation of future short-term rates plus a risk premium – the extra compensation for owning a security that will not pay off until sometime in the future. Investors should be paid for market uncertainty. Investing in U.S. Treasury securities does not present any credit risk, so the major risk factor is inflation.

As reflected by current bond interest rates, the threat of inflation continues to be very low. Lack of inflation pressure should continue to suppress any rise in intermediate-term and long-term bond yields, even as short-term interest rates are managed higher by the Fed.

Investors also need to understand the Fed’s current need to raise short-term interest rates. Historically, the Fed has used the Federal Funds rate as a mechanism to maintain price stability and arrest inflation. The most serious inflation fight occurred in 1981 when the Fed pushed the Federal Funds rate to 20% in order to stem 15% inflation. However, today the Fed does not have such worries and does not appear to be overly concerned about an inflation flare-up.

The goal under the current program is to normalize interest rates and not to stem an imminent inflation threat. Today’s program is without historical precedent. So, the impact on long-term interest rates this time could be even more muted than what has happened in the past, causing a further flattening of the yield curve.

Ever since the 2008 recession, short-term interest rates have been intentionally suppressed. As the U.S. economy has slowly recovered, the Fed has deliberated over the timing and extent of the inevitable rate "normalization" process. The financial markets are now witnessing interest rate normalization that will transpire over a number of years. After the first three rake hikes dating back to December of 2015, we expect the Fed to initiate at least two more rate increases this year. However, we do not foresee any significant influence on longer maturity segments along the interest rate spectrum.

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