Taxable municipal bonds: seasonal strength

The U.S. Treasury yield curve steepened during the third quarter, encouraging investors to extend duration. Pockets of volatility persisted, with the market focused on economic data and the U.S. Federal Reserve (Fed) attempting a soft landing. Taxable municipal new issue supply remained muted. But with favorable near-term valuations, we anticipate municipal bonds will outperform as supply trends wind down and demand strengthens following expected further Fed rate cuts. We think this makes current valuations an attractive entry point for long-term investors.

Key takeaways

• Taxable municipals exhibited positive performance as Treasury yields declined, but credit spread movements were benign, making valuations attractive going forward.
• Municipal credit resiliency can strengthen portfolios against a backdrop of economic uncertainty.
• Investors are looking to extend duration as the Fed cuts rates and the yield curve steepens.

Outlook

Moving past inflation fears

Overall core inflation is approaching the Fed’s 2% target due to several dynamics. Tight Fed policy has put loosening pressure on the labor market, housing has moderated substantially and global growth has softened overall.

In the labor market, the pace of job creation has dropped below pre-Covid trends, and unemployment has ticked higher. This is partially due to positive supply side dynamics, with prime-age labor force participation at its highest level in more than 20 years. But hiring has also slowed, and more people are spending longer periods of time unemployed. Some of the best leading indicators have softened, and we expect unemployment to move higher in future quarters, weighing on overall economic growth.

In this environment, it makes sense that the Fed began the cutting cycle. However, markets may be too optimistic about future cuts, even after the Fed started strong at 50 bps. The central bank has indicated a preference to move steadily, which likely means 25 bps cuts at each meeting with flexibility to accelerate or pause. This allows time to gauge the impact of rate cuts as the Fed moves toward a neutral policy stance of around 3.25% to 3.50%. We expect the Fed to reach that level in mid-2025.

Economic environment

• Inflation has trended lower since the first quarter. We expect Core PCE inflation to decline further by year end, driven by a decrease in both core services inflation and the cost of shelter.
• After increasing the fed funds rate 525 bps the Fed cut 50 bps at the September meeting. We expect measured rate cuts of 25bps through next summer, with the terminal fed funds rate dependent on inflation, wages and employment data.
• U.S. growth has been resilient, but the consumer is softening. Influential factors include unemployment data, consumer spending and levels of excess household savings. Capital markets are anticipating less risk of recession, but we continue to monitor developments closely.
• Uncertainty regarding the upcoming US election and the timing of future rate cuts will continue to cause short-term volatility in the rates market.

Municipal market environment

• Credit remains strong, with robust levels of rainy day and reserve funds. Governments are adjusting for normalization of revenue collections.
• We expect municipal defaults will remain low, rare and idiosyncratic.
• Taxable supply has been fairly steady compared to 2023. We anticipate that supply will slow after the first week of November while election results are digested.
• Demand favors owning duration, driven by higher-for-longer yields. Investors don’t want to miss out.
• Municipals have displayed strong relative performance this year.
• Despite tight ratios, municipals should generate attractive returns based on elevated income.