Municipal bonds’ performance versus Treasuries over the next few months is up to the Federal Reserve.
With widespread expectations for about $1 trillion in quantitative easing to be announced at the next Fed meeting, the Treasury market next month will become heavily dependent on the central bank as its biggest buyer.
Because Treasuries respond more directly than municipals to the Fed, which asset outperforms the other hinges on whether the Fed bolsters the Treasury market more than expected.
“The muni market’s lagged Treasuries in response to the potential benefits of quantitative easing,” said Anthony Valeri, fixed-income strategist at LPL Financial.
“If the Fed’s aggressive, I think munis will continue to lag Treasuries going forward,” he said. “If the Fed [isn’t], munis will hold their values better.”
All across the bond market, investors are pricing in the expectation that interest rates are going to stay very low for a long time.
The bellies of numerous yield curves, including the municipal curve, over the past 10 weeks or so have flattened to reflect the projected persistence of rock-bottom rates.
The economy began to sputter in the spring. The Fed has repeatedly explained its commitment to indefinitely low interest rates. Virtually everyone has pushed back his or her forecast for when short-term rates will begin to rise.
The lower-for-longer interest rate landscape has exerted itself like a rolling pin pushed from the front end of the yield curve toward the belly.
The influence of microscopic short-term rates has begun to seep into the intermediate portion of the yield curve, in the five-to-seven-year range.
Thomson Reuters analyst Robert Nelson, who manages the yield curves for Municipal Market Data, said investors have demonstrated more willingness to extend into longer maturities to pick up yield.
With tax-free money market rates essentially at zero, investors in triple-A rated municipal bonds have to go out to five years before picking up a yield with a 1% handle.
“You’ve had the Fed come out and make a pretty bold announcement that we are going to be in a low interest rate environment for some time to come,” Nelson said. “That gives [retail investors] a green light, if you will, to move out the curve a little bit.”
The Treasury bond market tells an unmistakable story for interest rates. Everything points down.
At the beginning of the year, the five-year Treasury yielded 225 basis points more than the one-year Treasury.
This spread described an anticipation that rates would rise significantly at some point before the five-year bond matured.
The spread has steadily collapsed all year, and now there are just 96 basis points between the one- and five-year yields. The shrinkage in that spread communicates a belief that rates probably will not rise for a while, and when they do they might not rise by much.
That conclusion squares with various other indicators of the future path of interest rates.
Trading in futures markets at the end of July suggested a 44% probability the Fed would raise its target for short-term interest rates by the middle of next year, according to Bloomberg LP.
At the end of August, this probability had shrunk to 21%. Now it’s 8%.
Analysts surveyed by Bloomberg in July on average thought the three-month London Interbank Offered Rate — now just 0.28% — would probably be 2% by the end of 2011. In August, the forecast compressed to 1.5%, and then to 1% in September. Now, the average forecast is 0.73%.
While municipal bonds have also baked in term spreads that reflect the likelihood of lower rates lasting, the movements are not nearly as pronounced.
The spread of the five-year triple-A municipal bond over the one-year has narrowed about 55 basis points in 2010, according to the Municipal Market Data yield curve.
While municipal rates track Treasury rates most of the time, LPL’s Valeri said the muni curve is less sensitive than Treasuries to the announcement due from next month’s Fed meeting.
The Fed’s message resonates more powerfully in the Treasury market than in the municipal market, Valeri said.
Most municipal investors are buy-and-hold retail buyers who are not interested in yields below a certain level. That naturally prevents the intermediate portion of the muni curve from flattening too severely, he said.
The upshot is that should the Fed unveil a bigger quantitative easing plan than expected, Treasuries will rally more than municipals. It also means that should the central bank use a smaller easing program, munis will hold up better than Treasuries, he said.
“The taxable market has been driven by the Federal Reserve [being] poised to buy a lot of Treasuries,” said Peter Coffin, founder of Breckinridge Capital Advisors. “They’re not poised to buy a lot of tax-free munis, so we lag.”
Coffin agreed the municipal market is less susceptible than Treasuries to an easing package that disappoints the bond market.
In the minutes of the Fed’s September meeting, released last month, governors described an economic expansion the pace of which has clearly slowed. With the unemployment rate at 9.6%, the labor market is improving only mildly. The housing market remains weak.
As the bond market began to price in just how much quantitative easing the Fed has planned for the second round, the yield spread of the 30-year Treasury over the 10-year Treasury reached an all-time high of 140 basis points.
So far, the Fed’s Treasury purchase programs have entailed buying bonds with maturities from two to 10 years, meaning more quantitative easing would compress 10-year rates relative to 30-year rates.
Estimates of how much quantitative easing the Fed might announce have ranged from around $500 billion to as much as $2 trillion in Treasury purchases.
Ralph Axel, rates strategist at Bank of America Merrill Lynch, wrote in a report Tuesday that around $500 billion in quantitative easing is “now close to being fully priced” into the bond market.
That means the Fed could drive bond yields even lower with a bigger easing program, or higher with a program of anything less than $500 billion, he said.
Complicating the Fed’s decision, Axel said, is that people don’t think the quantitative easing is going to work.
Consensus forecasts for real gross domestic product growth have come down since expectations of more Treasury purchases have crept into the market’s psyche.
The reservations about whether purchasing Treasuries will actually help the economy mean the Fed can’t simply achieve its interest rate targets by buying more bonds, according to Axel.
If it tries to shock rates lower by introducing a much-larger quantitative easing package of $2 trillion, it could result in people being quicker to pronounce it a failure if economic improvement does not occur right away.
Given Japan’s Lost Decade, he said the Fed risks “irreversible doubt and skepticism” if it overplays its hand.