The municipal bond market experienced blistering losses last year as Treasury yields repriced amid the surge in inflation. However, the first weeks of 2023 brought a far different story, and a more favorable backdrop has taken hold. Interest rates and credit spreads have declined sharply as investors begin to price in an increased probability that the economy could thread the needle with decelerating inflation and continued—albeit more gradual—economic growth. Through the first four weeks of the year, investment grade and high yield municipal bonds are already up 2.9% and 4.6%, respectively. Additionally, municipal bonds have appreciated faster than Treasuries, driving the municipal-to-Treasury yield ratio to 12-month tights.1 This rapid change in fortune begs the question: Is this market rally sustainable or just a bear market bounce?
To help answer this question, we examine three possible policy scenarios and assign a probability to each outcome in Figure 1: One in which the Fed pivots, one in which it holds rates relatively steady, and one in which it is forced to continue hiking rates.
PGIM Fixed Income’s Three Possible Market Scenarios (Fed funds rate, %)
PGIM Fixed Income as of January 24, 2023.
The Market’s Current Path
Under the first scenario, the Fed follows the course that markets have charted. Looking at the Fed funds futures curve, short-term rates are expected to reach a peak relatively soon. Subsequently, the market is expecting the Fed to pivot by cutting rates later in the year. This course of action would likely follow a string of sequentially lower inflation prints coupled with a slowing economy—opening the door for a steeper yield curve, led by lower front-end rates. Furthermore, confidence would continue to build that policy is on a more predictable path as 75 bp and 50 bp rate hikes are likely in the past. As a result, after cresting at the highest levels since 2009, implied rate volatility finally appears to be rolling over (Figure 2).
Rate Volatility Declines as Markets Price in a More Defined Path for Rate Hikes
Source: PGIM Fixed Income, BofAML. MOVE Index as of January 23, 2023.
As the Fed pivots, municipal rates would likely follow taxable rates lower given their strong correlation of 0.69 over the past 10 years. In addition to the muni/Treasury correlation, Figure 3 shows the strong, inverse relationship between Treasury rates and flows into/out of the municipal market. Therefore, open-end mutual funds would likely attract capital as investors grow increasingly confident that rates will drift lower. In contrast to the outflows of 2022 that led to rising yields, these inflows would likely lead to lower yields and positive returns in the municipal market.
Lower Rates Drive Muni Inflows (LHS: in $ billions; RHS: %)
Source: PGIM Fixed Income, Barclays, ICI as of December 31, 2022.
The Path that Pauses
Under the second scenario, the Fed reaches peak rates relatively soon, but decides to pause near a peak target of about 4.75-5.00% as it observes whether inflation will recede to its 2% target. Short-term rates would likely remain relatively unchanged and the yield curve could remain near its current, inverted levels or invert even further.
While other spread products may falter due to recession fears and tighter financial conditions, municipal bonds may benefit from a flight-to-quality as investors seek shelter in an asset class with lower default rates and lower probability of downgrades in credit ratings (Figure 4). In addition to the flight-to-safety, munis’ transition probabilities are lower due to their limited exposure to event risk, such as debt financed M&A or stock buybacks.
Municipal ratings transition less frequently than global corporates
Moody’s Investors Service as of April 21, 2022. Average one-year rating transition rates, 1970-2021, municipal vs. global corporate issuers.
In addition, rate volatility could continue to diminish as investors no longer fear the threat of even higher rates and muni investors could continue collecting the currently high tax-advantaged yields. With a yield-to-worst of approximately 3.10%, the muni index currently provides a taxable-equivalent yield of more than 5.0%, with a further benefit to residents of high tax states. This, too, could lead to additional municipal bond mutual fund inflows and spread tightening.
Stagflation Scenario Waning, but not Gone
Finally, under a third scenario, inflation reaccelerates and the Fed is forced to change directions. Instead of a downshift, the Fed continues rate hikes, possibly for a longer period of time than expected. This would drive rates higher than current levels, potentially across the entire yield curve. Higher inflation combined with a slower economy leads to a stagflationary environment in which spreads and rates move simultaneously higher. Stagflation fears were pervasive in 2022, leading to the sharp losses mentioned above. This “risk” scenario could push performance into the red as higher rates reduce the appeal of fixed income investments. Municipal bond spreads have already tightened versus Treasuries, with the 10-year municipal/Treasury ratio now sitting at an historically rich 63%. With municipal bond valuations somewhat stretched, muni yields would likely follow Treasury rates higher under this scenario.
While each of the three scenarios are possible, we believe the probability of positive outcomes for the municipal market is growing at the expense of the third, or “risk,” scenario. As the market’s reaction to this week’s FOMC meeting demonstrated, the probability of a Fed pause or pivot appears to be growing. Our scenarios currently assign a low probability to the stagflation outcome (10%) and a high probability to either recession (35%) or a soft landing (35%). While there are additional permutations (e.g. resilient or accelerating growth) that may result in positive or negative outcomes for municipal bonds, we are becoming increasingly optimistic over the potential for sustained, positive market performance over the remainder of 2023.
1The Municipal/Treasury Ratio compares the current yield of municipal bonds to U.S. Treasuries to determine how attractive they are by comparison.