Issuance is on pace for another year of record supply in 2026, even as the factors driving credit spreads are changing, Center for Municipal Finance Director Justin Marlowe told the Government Finance Officers Association Committee on Governmental Debt Management Saturday.
Marlowe, a research professor at the University of Chicago's Harris School of Public Policy, said 2022 brought a breakdown in the traditional relationship between credit spreads and macro fundamentals, like unemployment, housing starts and other data released by the federal government. Real gross domestic product growth and the consumer price index now have more of an impact, he said.
Since 2022, a much stronger relationship has developed between credit spreads and near-term technical factors, like treasury volatility, where it's much more a factor of "the immediate response of the market to real-time signals," Marlowe said in an interview.
"That really does have a lot to do with the institutionalizing of the buyer base, when you have big (exchange-traded funds) or hedge funds or private credit, and all kinds of other investors out there who are operating in both the municipal space and the taxable space at the same time," Marlowe said.
"They're just much more sensitive to thinking about a portfolio that spans a much broader area, fixed income, and so allocation decisions that in the past would have been limited to municipals now are affected by things in the taxable space, including and especially Treasury volatility," he said.
Technological advances involved in the institutionalizing of the buyer base also played a role, Marlowe said.
There are a lot more algorithmic traders, who have models that look at a range of factors — "they might be thinking about allocations to corporates, or they might be thinking about allocations to Treasuries, and so if those models see something happening in the shape of a Treasury yield curve or Treasury volatility, they're programmed to respond," he said.
Many times, there's a mechanical-type response that didn't exist five years ago, and algorithmic trading is an important part of that, Marlowe said.
Similarly, in the ETF space, there are specific formulas in use to try to maintain asset values and keep the arbitrage function working so the portfolio is exactly where it needs to be.
"The authorized participants, or the others who are involved with the arbitrage function on those ETFs, in many cases, are big banks and other financial institutions that are very sensitive to Treasuries and other kinds of near-term financial indicators," Marlowe said.
"The technology story extends to (separately managed accounts) as well, because so much of what SMA managers are having to do, they're managing hundreds or even thousands of individual SMA portfolios, and many of them have some commonalities," he added. "If something happens in, say, the Treasury market, and … suddenly you have an investor who's looking to do some tax loss harvesting, then there's a lot more forced selling happening in the near term."
When that forced selling happens, he said, account managers have to go out and buy the most liquid bonds. And when everybody piles into the most liquid bonds, that further drives volatility.
Overall, volatility in munis is down, Marlowe said, but on days when it's greater than usual, it's because of those dynamics.
Another change post-COVID is a divergence across states and localities in economic performance and investor sentiment. Economic policy uncertainty now is on par with during COVID, Marlowe said, and since the pandemic, there's been a lot more variation in state economic performance.
"The perception that some places just have a stronger economic future" is playing a role in that, Marlowe said. "I think the other part of it is a divergence of consumer sentiment and investor sentiment from actual economic performance. I call that the vibes economy," in which people feel worse about the economy than fundamentals suggest.
"People are kind of comfortable with the idea that what they think and what they feel matters more than what's actually happening in observable reality," he said. "There's no denying that it's an important part of what's happening out there right now."
People who manage SMAs — and other players, like investment advisory shops — are noticing a change in generational priorities, as well.
As family municipal bond portfolios turn over to the next generation, younger investors "do want other kinds of measurable investment objectives, whether it's social impact, sustainability, resilience, or … avoiding investments in communities that they disagree with politically, or communities that they think are not doing a particularly good job with things like climate adaptation," Marlowe said.
And as technology changes to allow faster processing of information and trading, the demands of those younger investors are becoming a more realistic ask of SMA managers, he added.
On the flip side, Marlowe pointed to some concerns around new technologies, most notably artificial intelligence. He cited the relative weight in the S&P 500 of the Magnificent Seven and noted, "the AI casino adds to economic uncertainty," pointing to a study by the Federal Reserve Bank of Dallas, which concluded, "AI might destroy humanity, end scarcity, or boost GDP by 0.21%."
In an interview, Marlowe said, "The reality is it's just a little too soon to know for sure, but there's no question that it manifests in municipals in a couple different ways."
One way is local government officials "see just how much of the stock market, in particular, is concentrated in AI right now, and … that has given a lot of local leaders real pause for skepticism," including around AI data centers, Marlowe said. "If it is in fact this big speculative bubble, then why should our community lose on that bet? Why should we jump on that bandwagon and run the risk of losing our future, because we put it on something that turned out to be a gamble?"
