Municipal bonds sank in value Wednesday after Federal Reserve chair Janet Yellen said interest rates may increase in early 2015.
During the question-and-answer portion of her press conference Yellen said that the Federal Reserve may end its asset-purchase program in October 2014, and that it could begin increasing interest rates six months later. Immediately after her speech, yields softened.
"There is definitely a chance that the Fed will increase interest rates before mid- to late 2015," according to a trader in Chicago.
Bonds with shorter maturities climbed as much as five basis points, while bonds maturing on the intermediate part of curve jumped up to seven basis points. Yields on the long end of the curve increased as much as three basis points.
Before Yellen's speech strategists had predicted that the Fed wouldn't raise
interest rates until mid- to late- 2015. Though the economy is slowly recovering, many industry experts have cited weak housing and manufacturing data and the inflation rate as reasons interest rates should be kept low.
Some traders point out that while the Fed is now looking to increase rates sooner, the rates might now jump up drastically.
"It appears that maybe the economy is better than the market thought, but I don't think that means interest rates will go up to 5%," said the trader, who is based in Pennsylvania.
The Fed also abandoned its 6.5% unemployment benchmark rate, the mark it had previously said unemployment would have to drop to before it considered raising interest rates.
"Removing the unemployment threshold might be the beginning of telegraphing to the market they want to increase interest rates," said a trader in Virginia.
Traders weren't surprised that the Fed had decided to discard the 6.5% benchmark.
After falling to 6.6% in January, the employment rate ticked up to 6.7% in February, with adverse weather conditions blamed in part for the increase, suggesting that the percentage may in fact be lower.
"The Fed never took 6.5% seriously," said a trader on the West Coast. "They know that the rate doesn't have anything to do with employment. Unless the rate changes entirely, it won't affect the market."
Going forward, Yellen said that the Fed would look to the inflation rate as its main indicator for when to end the bond buy- back program and increase interest rates.
"When the Fed set a 6.5% unemployment rate and a 2.5% inflation tolerance threshold above its 2% target as levels that would prompt consideration of substantive monetary policy adjustment, they had no idea that the unemployment rate would fall as fast as it has with so little movement towards the inflation target of 2%," Loop Capital Markets said in a report released on Wednesday.
The Federal Open Market Committee said tapering will continue with another $10 billion cut this month, meaning that the central bank will buy back $55 billion in March. The market hasn't reacted adversely to the Fed tapering back its bond-buying back program so far this year, after it had a "taper tantrum" following former chairman Benjamin Bernanke's announcement in June 2013.
"The market seems to be taking tapering with stride, but rising interest would be a different situation," said another trader based in Chicago.
With only two deals greater than $100 million expected in the negotiated market, primary market trading began slowly Wednesday.
"The market is pausing from last week's heavy issuance. Munis had a good performance leading to that, but the market is at a wall right now," said the West Coast trader.
The day's largest deal in the negotiated market came from the city of Holland, Ottawa and Allegan Counties, Mich., for $160 million of electric utilities system revenue bonds. Jefferies LLC is the lead underwriter. The bonds are rated Aa3 by Moody's and AA by Standard and Poor's.
"The city of Holland is an attractive issuance, because it is new credit," said a trader based in Pennsylvania.
Westchester County Local Development Corporation will issue a twofold deal totaling $110 million of Pace University revenue bonds. Series 2014A of the deal consists of $80 million of revenue bonds, while series 2014B is comprised of $30 million. The bonds are rated BB-plus by S&P.
There were no deals scheduled for over $100 million in the competitive market Wednesday.
"Volume is down 30% to 40%. Overall, munis are very healthy; there has been a good turnaround from six months ago. The market is just relying on new issuance," said a different West Coast trader.
Yields softened Wednesday, according to Municipal Market Data, with bonds maturing on the short-term curve climbing as much as five basis points, while bonds maturing on the intermediate curve jumped as much as seven basis point.
Bonds maturing on the long end of the curve reached up to as much as three basis points. Yield on municipal bonds fell throughout the curve, according to Municipal Market Advisors, with bonds maturing in 2024 and 2025 jumping as much as six basis points.
Treasuries weakened Wednesday, with the 30-year yield climbing as much as two basis points to 3.66%.
The 10-year benchmark and the two-year note gained eight basis points to 2.78% and 0.44%, respectfully.
