Interestingly, beginning somewhere between the end of August and early September, we began to speculate about what the Federal Reserve’s intentions were and if we were getting real inflation or not. What tipped us off was the U.S. Treasury yield curve started to rise at almost every data point.
So, as the yield on the 3-month T-bill was rising, the yield on the 2-year note was also rising, and so were the data points out to 30 years. There was a lot of talk about how the yield curve was flattening. Yield curves typically flatten during a period when the Fed is raising their rates. That period is called tightening. It’s only happened five or six times in the history of the U.S. Treasury, so it looked like it might start to happen again.
There have been a lot of articles written about it, but the truth is the yield curve hasn’t flattened. Yields have definitely gone up. However, since December 1, U.S. Treasury yields have risen across the yield curve, with the exception of T-Bills, and they’ve gone up almost on a perfect average of 0.44 basis points (or 0.44 percent). It raised close to 0.44% percent, on one side or another, on the 2-year, the 5-year, and the 7-10-20-and 30-year.
What We Think
It’s a little bit confusing to me because I think we should have been flattening. The Fed will probably raise rates after the March meeting. And if and when they do, that short end of that yield curve – 1-year, 2-and 3-year Treasuries – should rise a lot more and cause the curve to flatten.
If you look back to 2004-2006, the Fed raised rates 0.25 basis points at every meeting over two years. The 2-year Treasury basically went from 1% to 5.25%. But the 30-year Treasury stayed the same – at 5.25% – and it was flat.
There was a period during those two years that the yield curve inverted when T-bills were yielding more than 30-year bonds. That happens every time we have a period of Fed tightening.
History tends to repeat itself so it could happen again. There is speculation that the Fed will be raising rates three-to-four times in 2022.
On the Municipal Side
Municipal bonds are not as actively traded as Treasuries are. You can’t look at the yield curve minute to minute as we do with Treasuries. There are indicators that tell us whether interest rates are rising or falling, or what they are doing at any part of that yield curve. But it takes more than a minute of trading to determine that.
The amount of cash coming into the municipal bond market over the last year is holding yields low. There is more cash to be invested in municipal bonds than there are bonds. It is supply and demand that keeps the yields low.
Yields on good quality municipal bonds – and I stress “good quality”– used to trade at 110%-to-116% of the yield of a Treasury. That was pre-COVID. Tax-free municipals were trading at higher yields than Treasuries. Today, in a 10-year space, U.S. Treasuries are yielding 1.83%. You would be lucky to get a good quality municipal for 1.5%. Essentially, it has flip-flopped because of all of the cash coming in and because of speculation.
We’re in the second year of a new presidency with the speculation of rising taxes. People have been shifting into municipal bonds because they are tax-free, and because the credit quality of a good municipal is second only to U.S. Treasuries. Investors have decided it is a safer and better place to be. All of this has contributed to municipals’ steady demand.
Changes at the Federal Reserve
Historically, the Federal Reserve makes their moves independent of anything Congress, the Senate or the President are doing – unless they throw something in that is going to send inflation off the rails, which no one is speculating to actually happen. We will continue to see a steady Fed with Jerome Powell as Fed chairman. However, they may become a bit more hawkish than dovish.
Sarah Bloom Raskin is a former regulator who will be the Fed’s vice chair for bank supervision. She may have a heavier hand than Randal Quarles, who had a lighter touch. Personally, I don’t know what power that title will give her. I haven’t heard any speculation having an impact on the Fed at all.
There Are ‘Good Deals’ To Be Found
Regardless of what goes on at the Fed, in our world there are good deals to be found today in the secondary market in A-rated municipal bonds backed by insurance.
I don’t think we are going to find any real deals or exceptional yields when talking about the Triple-A market, which are basically Treasuries at high quality.
We don’t typically buy Triple A-rated municipalities, especially here in Pennsylvania where there aren’t very many anyway. We like to get the higher yield out of the A-rated, or the AA-rated. Today, I still like muni high-yield.
Other people have been getting out of muni high-yields, but that’s more of a profit play. People that own these were up 8%-to-9% last year, which is why it seems they’re just taking some money off the table.
For people taking interest dividends, I think it is a fine place to be.