Municipal Bond News 9/26/22

Decade-High Municipal Bond Yields…Treasury Yields Highest Since 2007…Powell’s Gloomy Outlook…Fed’s Updated Economic Projections…75% Odds of 2023 Recession, Gundlach…Wall Street’s Recession Indicator…California Misses Revenue Forecast…Calls for PREPA Receiver, Litigation, Mediation……

Decade-High Municipal Bond Yields…Tax-free bond yields are the highest since 2013, with top-rated municipal bond yields at close to 3% for ten-year maturities and 3.8% for longer-dated municipal bonds. Since last week, tax-free bond yields have climbed 15 basis points, while taxable Treasury bond yields are also higher. Tax-free bond yields could climb higher as more fed-funds rate hikes are in store before year-end. However, the majority of fed-funds rate hikes are arguably in the rear view. Turmoil in financial markets comes amid steep fed-funds rate hikes which have led investors to flee to not just state and local government bonds, but just about every asset class except money market funds. The municipal bond market is unlikely to turn around until rates stabilize experts reckon. Tax- free municipal bond indices have lost over 11% so far this year, perhaps the worst showing since the 1980s.

Treasury Yields Highest Since 2007…U.S. Treasury yield hit 4.25% for two years for the first time since 2007. Two-year Treasury yields have risen for twelve straight days, a first since 1976. Sharply higher yields reflect market expectations of a 4.50% to 4.75% peak fed -funds rates by mid-next year. The worst bear market in bonds for a generation comes as rates are expected to remain high for some time. Globally, central banks are reversing years of ultra-low interest rates, mostly triggered by COVID-19, to bring down high inflation.

Powell’s Gloomy Outlook…Fed Chair Powell delivered his gloomiest outlook on the U.S. economy along with the third consecutive 75 basis point hike in the fed-funds rate. “We have got to get inflation behind us. I wish there were a painless way to do that,” Powell added “There isn’t.” Powell has long spoken of a ‘soft landing’ contending that the central bank could tame rampant inflation without tipping the world’s largest economy into a recession. As recently as July, central bankers were “not trying to have a recession, and we don’t think we have to.” That has changed, Powell explained “The chances of a soft landing are likely to diminish” because monetary policy needs to be “more restrictive or restrictive for longer.”

Fed’s Updated Economic Projections…Central bankers expect “core” inflation which excludes volatile food and energy to recede from 4.5% by the end of 2022 to 3.1% by late 2023 and 2.3% by late 2024. As of July, the Fed’s preferred gauge, the core personal consumption expenditures price index, stood at 4.6 per cent. Higher unemployment, 3.8% by the end of 2022, and 4.4% over the following two years. The Fed slashed its GDP growth estimate to 0.2% this year, followed by 1.2% GDP growth next year and 1.7% in 2024. Fed officials project rates to rise to 4.4% at year-end before peaking at 4.6% in 2023, and dropping to 3.9% in 2024. Futures markets see a fourth 75 basis point rate hike in November-22, followed by a 50 basis point rate hike in December-22. Amid differing opinions on the Fed’s projections, there is consensus that the risks are tilted towards weaker growth and higher unemployment.

75% Odds of 2023 Recession, Gundlach…”But we’ve been tightening now for a while. And the impact of these tightening’s is going to cumulate into a recession,” Bond King Jeffrey Gundlach puts 75% odds of a recession as early as next year. The Fed’s path for rate hikes could reduce U.S. GDP growth by 0.6% next year, and 0.3% in 2024, Moody’s estimates. New home sales, a trusted recession warning, are down 19.6% from a year ago. A rule of thumb is that when the six-month average of new-home sales is down 20% to 30%, a recession normally follows with varying lags. Moody’s assigns close to 60% odds of a recession within in the next year. A strong dollar, at a twenty- year high, is a threat to U.S. exports, which make up over 10% of GDP. Oil prices slid to the lowest this year, amid concerns of a looming economic global economic slowdown.

Wall Street’s Recession Indicator…Sounding a loud recession alarm, the yield curve or the Treasury term structure is deeply inverted, with the two-year United States Treasury yields about 50 to 60 basis points higher than longer- dated Treasury bonds. A stark contrast from a year ago when two-year Treasury yields were about one percentage point lower than 10-year yields. Last year, the Fed viewed inflation as ‘transitory’ and did not see a need to rapidly raise interest rates, so short-term yields were lower at that time. Today, the Fed is amid aggressive rate hikes, and the U.S. economy has contracted for two straight quarters. Historically, the largest inversion between the 10- and two- year Treasury yields occurred during the recessions in the early 1980s, as then Federal Reserve Chairman Paul Volcker was aggressively raising interest rates to tame inflation. In late 2000 when the internet bubble burst, the yield curve inverted before the recession in March 2001. The yield curve also foretold the global financial crisis that began in December 2007, initially inverting in late 2005 and staying that way until mid-2007. A yield curve inversion has preceded every U.S. recession for the past half century.

California Misses Revenue Forecast…California’s income tax revenue collection is 11% below expectations so far this year. Golden State total revenue for the first two months of Fiscal 23 is 8% below forecast. California is one of sixteen U.S. states that have seen unemployment tick higher in August, warning of an economic slowdown. California’s revenue miss is a sign of a decelerating economy. With its fortunes tied to economic swings, California has socked away billions of dollars into reserves to help weather economic cycles.

Calls for PREPA Receiver, Mediation, Litigation…PREPA “may not shelter in bankruptcy indefinitely while its creditors go unpaid,” bond insurers and major bondholders of Puerto Rico electric utility bonds are asking to dismiss the electric utility’s bankruptcy petition. Bondholders are seeking to appoint a receiver that could “set affordable and sustainable electric rates sufficient for PREPA to pay its debts and improve the quality of its service.” But, the oversight board has warned that such a move would “put the present and future economy of Puerto Rico at risk.” Bondholders say that politics got in the way of a previously negotiated deal that would have reduced PREPA’s debt and allowed the utility to access about $12 billion in FEMA funds. The only way for PREPA to reach a debt-cutting deal and emerge from bankruptcy is to first let a court hear key disputes over bondholder collateral and security interests, the board says. There is dissent within the oversight board, as at least one member, Justin Peterson, is in favor of a receiver to control PREPA finances. The mediators, who are three federal judges appointed by Judge Swain, have asked for simultaneous mediation, litigation and plan of adjustment creation. The board is hopeful of striking an agreement with a major creditor group, and a court hearing this week will unfold more details.

Compare 30-Year taxable U.S. Treasury yield 3.65% to 30-Year tax-exempt muni bond yield “AAA” 3.83%; “AA” 4.32%; “A” 4.70%; “BBB” 4.77%. For investors in the 35% tax-bracket, a 4.7% tax-exempt yield is equivalent to a 7.2% taxable yield. Top rated long-term tax-free bonds yield 105% of comparable taxable U.S. Treasuries.