We know what many muni investors are thinking: The Fed raised rates, so now municipal bond yields will take off.
If that sounds right, we urge you to reconsider.
Conventional thinking posits that the Fed raises interest rates to put the brakes on inflation. But Wednesday’s hike, the first in almost a decade, comes amid weak growth.
As the Fed described it after its meeting, there is evidence of economic growth, but it’s tepid. Exports are soft, prices of energy and non-energy imports are down and inflation is still well below the Fed’s 2.00% target rate.
In other words, don’t expect steep, imminent rate hikes after this one.
“The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run,” the Fed said in a statement.
Behind the move
The Fed’s move comes as the economies of our major trading partners are weakening. China anticipates slower growth in 2016, and Europe is considering increasing its quantitative easing.
As we’ve commented previously (“Fed Fever and the Muni Investor,” “The Media’s Interest Rate Myth”), inflation drives the long end of the yield curve. With minimal inflation on the horizon, we should see higher prices and lower yields on long-term bonds while short-term rates rise. In short, a flat yield curve.
Consider that only a day after the fed funds rate hike, that’s exactly what happening: Yields on both 30- and 10-year Treasuries have declined.
For most investors, it’s counterintuitive. Traditionally when the Fed raises rates, long-term rates follow. But not this time. The Fed’s action yesterday was more a political move than a bulwark against spiraling prices and the threat of runaway inflation.
Remember, the Fed can only control the shortest of interest rates. Long-term rates are determined by investors’ expectations of future inflation. The Fed hike is likely to squelch inflation even more.
Strong muni market
The Fed’s decision comes amid a strong muni market. Overall, returns on munis this year have exceeded corporate bonds and many other securities, the second consecutive year of stellar performance. Robust returns have attracted even non-traditional investors unable to take advantage of the tax exemption.
High demand, along with a tight supply and a low-growth environment should be a clear signal to even the most intractable fixed-income investors waiting for yields to jump: Delaying will be costly.
