Fixed income performed well across a broad spectrum of sectors in the third quarter, led by a continued recovery in the high yield space.
Year to date, treasuries and agencies added to an already strong year, followed by corporate bonds and tax-free municipals. Uncertainty remains high as the market continues to parse an ever growing stream of news regarding the economy, Covid-19, and the potential implications of the November elections.
Review
The table below summarizes the returns of a few major fixed income indices.
The Election: Possible Changes For Munis
There has been considerable attention in the media regarding election polls which suggest there could be a “blue wave” in November. This could lead to a significant change in policies which affect the Municipal Bond market. We do not know how valid these polls are or the likely outcome of the elections. However, it is interesting to see how these elections could affect the market for Muni bonds. The bullet points below shows some of the possible policy changes and their impact on municipalities. In general, a blue wave would have a positive impact on Munis.
Muni Impact: If Democrats Control the White House and Both Houses (Blue Wave)
Possible Policy Changes:
Tax Rates Rise
Positive: Higher Taxes/Brackets Make Munis More Attractive
More Fiscal Stimulus
Positive: Will Target $1 Trillion for Muni Help (Credit Positive)
Tax-Free Issues for Refunding
Positive: Makes it Cheaper to Refund Issues
Increased Infrastructure Incentives
Positive: Possible Reinstatement of Build America Bonds
Repeal of SALT (Abolish Tax Limitations for State Income & Property Taxes)
Negative: Makes In-State Munis Slightly Less Attractive
Curve Steepening: A Problem For The Fed?
The Fed has provided massive amounts of liquidity to the bond markets during the pandemic induced recession. They have also been “jaw- boning” for higher rates of inflation by saying they are willing to tolerate inflation above their 2.0% target. Simultaneously, they have announced their plan to keep short-term rates low for at least a couple of years. Since we are in the early stages of an economic recovery, it seems likely that rates on longer-term maturities should rise relative to shorter-term rates. This is already beginning to occur.
The first chart below shows the yield curve is beginning to steepen. The orange line measures the difference in yields between a 3 month UST and a 10 year UST, and the blue line shows the Fed Funds rate. The curve has already risen from a negative spread (inverted yield curve) to a positive spread of over 0.70 bp’s. We believe this spread will continue to widen as the economy recovers. The chart shows this has happened in the last 2 economic cycles. The first cycle occurred after the terrorist attacks on 9/11/01, and the second cycle during the Financial Crisis in 2008-2009.
The chart below is for the 30 yr UST. It shows yields have risen from a low of 0.83 bp’s during the recent pandemic panic in March to a level of 1.64% today. This level is now trading above the 200 day moving average which means we have likely seen the lows in yields for the 30 yr UST bond for this cycle. This poses a conundrum for the Fed. The low long-term rates in UST during the pandemic have supported the housing market by lowering the cost of a mortgage for buyers. This has helped to offset some of the weakness in the economy due to the pandemic.
Higher long-term rates would cause mortgage rates to increase which would likely cause the housing market to weaken. Rates for longer-term maturities are largely dependent on inflation expectations. For example, why would investors lock up yields for 30 years at 1.0% if they think inflation is going to be higher than 2.0%? This would give them a negative expected annual real rate of return of -1.0%. The Fed has created a potential problem for itself by setting these expectations for the markets. The goal of having higher inflation is not consistent with low long-term interest rates.
The Economy
There are some headwinds for the economy which will tend to slow down the speed of the recovery, the rate of inflation, and the rise in long term rates. First, all the developed countries have negative demographic trends due to aging populations. There aren’t enough young people entering the labor force to offset the number of older people leaving the work force. This acts as a deflationary force. Second, studies have shown when levels of a country’s debt get over 90.0% of GDP their economy experiences slower rates of economic growth. The amount of Federal debt in the U.S. is now over 135.0% of GDP and is rising rapidly. This number will continue to worsen since there is no political will or concern about the impact of rising debt levels on our economy.
Finally, digital technologies are creating supply side shocks which are very deflationary. Some examples are e-commerce platforms, ride-hailing services, and Air BnB. During the pandemic Zoom has enabled workers to work from home. This has an impact on the need for office space, transportation, restaurants, etc. There has been an enormous impact on business travel as virtual meetings have increased. Amazon has pressured retail stores. Storefronts in malls are closing. The pandemic is not the sole cause for this trend. It has merely accelerated the movement to online shopping.
Conclusion
We are in the early stages of an economic recovery. We believe we are in a “lower for longer” interest rate environment. There will probably be pressure on long-term rates due to a pickup in economic activity. However, the deflationary forces mentioned above are likely to temper inflation and keep it under control. This means yields in the longer part of the curve could continue to rise in the intermediate term, but won’t go significantly higher in the longer term.
We also believe Munis are likely to benefit from the elections. The credit quality of States and Local governments will be helped by Federal aid, and higher tax rates will make Munis more attractive on a taxable equivalent yield basis.
Progress on the pandemic will continue to be made. Mortality rates have fallen as the medical profession is learning how to treat victims of the disease. Faster and more reliable testing, and progress on vaccines are encouraging.