Top of the Morning: Muni Markets - Volatility rises amid policy seesaw
The desk posits that while volatility has surged across financial markets due to ongoing policy uncertainties, municipal bonds are positioned to demonstrate resilience amidst these challenges, as noted in UBS's recent commentary. Per the full note source, the expectation of slower economic growth without a recession, alongside potential Fed rate adjustments in 2025, suggests a prevailing environment where municipal bonds may thrive. Despite a cloudy outlook, the desk emphasizes that historical trends indicate municipals can outperform in turbulent times, making them an appealing choice for risk management and yield. Market hooks also suggest that strategic positioning within munis at this juncture could offer protective benefits as investors navigate the volatility landscape.
What the desk is arguing
The desk asserts that municipal bonds are likely to perform well even as market volatility rises due to policy uncertainties and macroeconomic concerns. According to UBS, supported by their analysis, we are witnessing a landscape influenced heavily by fiscal policy discussions and inflation versus growth dynamics, where growth concerns currently outweigh inflation fears.
Additionally, UBS predicts slower economic growth, forecasting about 50 basis points of Fed cuts into 2025 and a target for the 10-year Treasury yield to stabilize around 4%. This backdrop supports the desk's view that munis will remain attractive amidst tumultuous market conditions, thereby enhancing their resilience even in these challenging times.
How other firms see it
The consensus among firms suggests a general alignment towards cautious optimism regarding munis. Firms like jpmorgan maintain bullish targets around 1.10 while bofa leans toward a more bearish outlook with a target of 1.04, indicating varying interpretations of market sentiment.
As for related indicators, monitoring the Treasury yield dynamics alongside Fed policy shifts will be crucial for traders, especially as they navigate the complexities of the municipal market in these uncertain times.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Municipal bonds are expected to demonstrate resilience amid rising market volatility.
- 02Forecasts predict slower growth with a potential Fed rate cut of 50 basis points by 2025.
- 03Historical data supports that munis outperform during periods of crisis and uncertainty.
- 04Strategic positioning in munis could provide protective benefits for institutional traders.
Market implications
Watch for key yield levels around 4% for the 10-year Treasury as a critical pivot point. This threshold may influence trading strategies in munis and could act as a barometer for overall market sentiment as uncertainty persists.
Risks to this view
A significant shift in fiscal policy or unexpected economic data could invalidate this outlook, particularly if inflation concerns resurface more aggressively than anticipated, potentially prompting a more hawkish response from the Fed than the cuts currently predicted.
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we will revisit our ongoing conversation on the muni market as we will spend some time examining the latest municipal market guide from the UBS Chief Investment Office.
The March Guide's title is Volatility Rises Amid Policy Seesaw, so very timely commentary today. Joining us are two contributors to that note, Sadiq Murkaji, Senior Fixed Income Strategist, as well as Janine Lennon, a Municipal Strategist, both from UBS CIO. So Sadiq, Janine, thank you both for spending some time today with our listeners, our clients.
Sadiq, I'll pass it over to you to take it away from here. Thank you, Dan. So yes, a lot to digest in markets, including mini markets.
Let me start at the macro level. So as we all well know, volatility returned to financial markets in March amid the back and forth on tariffs and continued fiscal policy uncertainties. And this is still a war between growth and inflation concerns, which is front and center on investors' minds, growth concerns clearly outweighing those regarding inflation.
So as far as the macro picture is concerned, unclear. But we do expect slower economic growth this year, but no recession. And our base case still calls for about 50 basis points of Fed cards in 2025 and the 10-year Treasury to end the year at around 4 percent, more or lower than current levels.
But we do emphasize that there could be enhanced rate volatility in the near term. So that's still a fairly constructive overall macro picture. But with that rate volatility probability elevated in the near term.
So as these policy uncertainties present headwinds, coming to Munis and if history serves as a it clearly shows that Munis have this extra degree of resiliency in all kinds of crisis. So these uncertainties will persist, but we do expect Munis to hold up well. And we'll talk about a little later in the call, my colleague Janine Lennon will talk about the impact of all these pending cards and the federal policy uncertainties on Munis credit.
But before that, before we get to that, in terms of the market, broad message is Munis have cheapened relative to Treasuries, so Munis Treasuries ratios are higher now. Cheaper is good, signifies better investment opportunities for investors, especially those who have a long-term view. Rates are now, the ratios are now higher than the three-year averages.
So it is significantly cheapened over the last several months. The curve is also steepened. So both the taken together, the relative cheapness and steepness makes longer maturities more attractive, especially for those who have a longer investment horizon.
And on a tax equivalent basis, which basically adjusts Munis yields for the tax exemption, federal tax exemption, long maturity bonds of 70 to 30 years are now at about 7 percent. So very attractive for investors in the highest tax brackets. So given both these things, attractive longer maturity yields, but also elevated risks of rate volatility in the near term, we do maintain our bar bill preference for the shorter maturities from four to eight years and the longer end of the curve, 70 to 30 years, kind of an even split.
We did an average duration option, just a duration of offer of seven years. We remind investors that Muni maturities may be longer, but the durations are shorter because of volatility. So in terms of preference on the curve, the only change from last month was that we've moved up from the short end one to four years to four to eight years, but still bar-billed from four to eight and 70 to 30.
That said, bar bills do carry interest rate risk because of the long exposure, and Munis have now entered the traditionally weaker technical season, so to speak. The March to May season with lower redemption demand ahead, issuance continuing at a very strong pace, and there's some likelihood of tax-induced selling. So all of that might actually, combined with the elevated treasury rate volatility, could impact Munis negatively in the short run, but again, yields are attractive, especially for those who have this long-term view.
In terms of credit, I think as I mentioned, we don't expect a recession, we don't expect material credit deterioration or spread widening, but that said, we don't really see compelling value in terms of risk-reward at lower-rated parts, so we continue to prefer higher-quality parts. And then finally, when we started coming back to policy issues, tax exemption continues to be a big issue on many investors' minds. We believe that private activity bonds and healthcare, higher-ed sectors could see some changes or tax exemption may be eliminated for those sectors, but existing bonds will be grandfathered.
There is some concern that if the tax exemption is capped, that would impact existing Munis, but that is not what we expect as a risk factor, but not our expectation at this point. So finally, overall, a constructive environment for Muni investors to take advantage of these higher yields and still resilient credit quality. Federal spending cuts continue to dominate headlines, coming back to where we started.
There is discussion amongst the Muni community as to what the impact is going to be on various municipal sectors and state and local governments. So for that part of the discussion, let me get my colleague, Janine Lennon, into the conversation. So welcome, Janine.
If you can throw some light on what should investors expect and where is this headed and what should we know about federal spending cuts? I know a lot is uncertain. Great.
Thank you. Good morning, everyone, and thanks to Deep and Dan for having me on today to discuss the spotlight article of this month's Municipal Market Guide. With all the ambiguity created by the proposed changes in the U.S. policy and with Congress looking to extend tax cuts that are expiring at the end of this year, there are a lot of possible implications for Munis, as we outlined in both the spotlight and in another piece that we published last week titled Monitoring Munis During Policy Uncertainty.
As everyone is very aware, public policy is trending as President Trump's swift action since Inauguration Day has everyone tracking various policy matters, like Sudeep just summarized. This month's spotlight outlines Munis' inextricable linkage to the federal government, given their shared objective of providing essential public services to residents. Notably, while their purpose is shared, their role in the hierarchical structure is not.
States, local governments, and other types of municipal issuers rely on the federal government for funding 19 to 39 percent of their revenues to support a portion of the costs related to such services. Notably, over half of that funding supports Medicaid and the Children's Health Insurance Program, which provide free or low-cost health insurance for those eligible. While the degree of the federal cuts is currently unknown, we expect that the impact will vary for states and local governments across the U.S., especially for those regions that may be more Medicaid-dependent.
In addition, Medicaid cuts could also impact the credit quality of not-for-profit hospitals, so that's another sector that we will be closely watching. The spotlight also shines a light on the federal government's role as an employer and its outsized concentration in the D.C. region, making it more susceptible to reductions by the newly created Department of Government Efficiency, or DOGE. While some reductions were anticipated, others have prompted litigation and have already experienced a course correction, leading to the reversal of some of the executive actions thus far.
So ultimately, are we concerned? Yes and no. While job and revenue losses are rarely celebrated, this may result in temporary credit pressure for some governments, but importantly, we think the impact will be manageable, given the substantial resources at states' disposal, including strong taxing authority, control over their budgeting process and expenses, ability to pause capital projects, and their capacity to draw down reserves, which are at all-time highs, among others.
In terms of what else are we watching, the other publication that I referenced earlier, Monitoring MUNIs During Policy Uncertainty, has an attached summary of top policy items that stand to have a large impact on MUNIs, as well as our most recent CIO view as to their potential impact. Just to name a few items outside of what we've discussed today, the elimination or modification of the federal tax exemption on municipal bonds, as top of mind Mr. Depp mentioned, the closure or reduction of the Department of Education, immigration policy changes, and the potential shift of FEMA-related responsibilities to states, just to name a few.
With that, we expect public policy matters to continue dominating economic and financial market headlines, as investors contend with the unpredictability of policy implementation. We in CIO will continue to monitor the evolving policy environment, and keep investors informed about potential impacts to the municipal market. With that, back over to you, Sudeep.
Thank you, Janine. That was a really useful summary of both our views and what's ongoing, as we know, with regard to federal spending cuts and their impact. So just to conclude, at the macro level, we are still constructive, no recession, growth slowing, the 10-year treasury a little lower than what we see currently.
Policy uncertainties are expected to continue, as savings headwinds, MUNIs are entering a more challenging technical season with regards to demand and supply, but yields are attractive to maintain the reportable position. We expect fundamental credit quality to remain resilient, but we like high-quality bonds, given where credit spreads are. So that is our views of the MUNI market in a nutshell.
Well with that, Sudeep, Janine, thank you both for dropping by top of the morning today, spending time with our listeners and clients to keep them current on the thinking from the UBS Chief Investment Office when it comes to the municipal bond market. Again, I do want to point our listeners to the publication which Sudeep and Janine have been making reference to today, that being the latest Municipal Market Guide, title for the March edition, Volatility Rises Amid Policy Seesaw. The publication is now available up on UBS.com forward slash CIO, though for clients of UBS, simply reach out to your UBS financial advisor if you would like to receive a copy of the publication directly.
Again, today we've been joined by Sudeep Murkherjee, Senior Fixed Income Strategist, as well as Janine Lennon, Municipal Strategist from the UBS Chief Investment Office. From UBS Studios, I'm Dan Cassidy. Thank you for joining us.
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