Summer is here, replete with vacations, barbeques, myriad outdoor activities, and, of course, ample celebration on the heels of the New York Knicks winning their first NBA championship in 53 years.The month of July is likely to extend the usual fireworks as we celebrate the 250th anniversary of our nation's independence. The FIFA World Cup notches up the excitement levels, given the United States last hosted the event in 2003 (women's) and 1994 (men's).
This is also a time to reflect on the first six months of 2026 and reevaluate goals and objectives. As I think about my 2026 muni market outlook, the asset class is meeting, and in some respects, exceeding expectations. Oftentimes, the municipal bond market has this unique ability to insulate itself from macro events and conditions that routinely impact the U.S. Treasury market. Through geopolitical-driven market volatility, shifting central bank messaging and both good and bad policy developments, munis have positioned themselves as the darling of fixed income.
The best way to describe the situation with Iran is guarded optimism. With a June 17 memorandum of understanding (MOU) in place for an initial 60-day period, the Strait of Hormuz is operational, but not without challenges, conflict, violations and limitations. Although transit bottlenecks are slowly freeing up, traffic significantly trails pre-war levels.
Safety and security concerns shadow passage through the Strait and actual flows of crude oil and liquefied natural gas are difficult to quantify. Despite ongoing diplomacy, Iran is showing no signs of ceding authority of the passageway. But the good news is, global oil prices have retrenched between 12% and 15% since the signing of the MOU.
While the conclusion to the Iranian crisis has multiple possible scenarios, I do not expect an end anytime soon. We must keep in mind that the MOU is a framework on which to build a final resolution. It is by no means a final deal. Hostilities between Israel and Lebanon remain ongoing despite a ceasefire called for in the MOU. The erratic nature of the Iranian regime and the potential for renewed closure of the Strait foster global uncertainty with unrelenting shocks to the financial markets.
In my view, enduring normalization of oil prices and bond yields requires a definitive end game. It is appropriate to remain somewhat gun-shy given the series of fits and starts surrounding the Iranian crisis. Safety issues and concerns will not quickly disappear and although the effects of lower oil prices, should they endure, would likely relieve inflationary pressure, we must be mindful of any false sense of security. To complicate matters, we will be monitoring escalating tensions between Russia and Ukraine.
Throughout the second quarter, bond yields continued a tug-of-war, but perhaps with somewhat less tug relative to the first quarter despite the geopolitical drag. It is interesting to note that at the beginning of the year, the Treasury 2s/10s spread approximated 72 basis points, while the same spread finished at about 30 basis points on June 30. This observation rests with a meaningful flattening of the Treasury yield curve given a shift in Federal Reserve expectations. Let's recall the markets priced in a series of rate cuts early in the year, effectively holding down the two-year benchmark yield.
Elevated inflationary pressure coupled with a fairly resilient economy led to a repricing of monetary policy and provided a pathway for higher short-term rates. Corresponding increases in long Treasury bond yields during this time were not as dramatic, as demand for long-duration outpaced concerns over mounting federal debt, heavy Treasury supply and inflation. As the first half of 2026 moved on, the recession needle receded quite a bit and the higher-for-longer narrative grew louder thanks to well-anchored longer-run inflation expectations, while sentiment called for measured long-term growth.
The U.S. Treasury benchmark 10-year yield began the year at 4.19%, advancing to a year-to-date high of 4.67% on May 19 thanks to the confluence of intensifying tensions with Iran that pushed oil prices higher, the higher-for-longer rates with inflationary concerns scenario, and general fiscal worries. Of note, the selloff of U.S. Treasury securities participated in a global bond market rout on that day. The benchmark 30-year yield, which entered 2026 at 4.86, hit a high of 5.18% on May 19, before retreating to a tighter trading range throughout the month.
Although muni bond yields generally directionally tracked their Treasury brethren during Q2, muni outperformance prevailed thanks to technical resiliency. Most notably, SMA-led demand in April limited upward movement in muni yields while UST yields were more responsive to macro conditions. This dynamic caused relative value ratios to decline, making munis more expensive than Treasuries. May's Treasury yield spike brought munis along for the ride, but at a slower pace. Of note, muni credit fundamentals continued to hold steady throughout the first six months of 2026.
I expect the muni market to stick to its knitting through the balance of the year. Municipal bond investors remain well-positioned to capture yield and income opportunities and taxable equivalent yield calculations provide a strong argument for tax-exempt allocations. I expect flows to remain strong through yearend and suitably high enough supply to meet demand. A steep municipal yield curve should continue to promote duration extensions, with SMAs remaining active participants.
Bond yields took on a seesaw bias in June. Inflation expectations eased during the month — sort of. Geopolitical concerns eased last month — sort of. I do not mean to be so wishy- washy, but I have to call it like I see it. While the natural inclination is for bond yields to fall on abating inflationary pressure, the markets remain susceptible to episodic volatility. Without a fully signed, long-term deal with Iran, the higher-for-longer sentiment may prevail and the supply chain disruption could extend inflationary risk to the upside.
June brought us the first Federal Open Market Committee meeting with newly minted Fed Chair Kevin Warsh. Market expectations were high going into the meeting, but there was little to no chance of a cut in the fed funds rate. As I anticipated, participants removed their easing bias from the conspicuously shorter policy statement — a significant point of contention at the April meeting. This may have signaled a hawkish move, along with the chair's repeated assertion the Fed is committed to its 2% inflation target.
In my view, we have a very smart, yet shrewd, individual at the central bank helm. While I have complete confidence in Mr. Warsh's commitment to a fully independent Fed, I do think he prefers an easing bias, yet he is willing to be patient. June's gathering came with a fresh summary of economic projections, with "dot plots" from the participants signaling a less dovish stance.
The post-meeting press conference was closely parsed for policy nuance and any operational changes that deviated from the Jerome Powell Fed. All in all, the UST 2-year yield interpreted the meeting as justification to move higher, as the probability of future easing was repriced lower and the outlook for policy bias moved to more restrictive ground.
We are in a period where data-dependency shows its relevance. The Fed will be closely watching the inflation reports for any signs of easing energy prices now that oil is flowing through the Strait of Hormuz. However, it may be too soon to establish a trend, as the next FOMC meeting is scheduled for July 28-29, which will not include a Summary of Economic Projections (SEP).
The internal Fed debate will also question the effectiveness of raising rates as a way to combat supply-side inflation, brought on by certain factors, including elevated energy costs, tariffs and supply chain disruptions. The inflation currently being experienced is not demand-driven. Accordingly, the Warsh Fed must walk a fine line as it marches the economy toward price stability. Perhaps, if need be, a cosmetic rate hike could be appropriate to anchor expectations, unless evidence shows inflation is penetrating a broader demand backdrop and necessitates more aggressive tightening.
Clearly, Fed officials want to see indications of easing concerns over potential energy and supply shocks. The June meeting was all about giving legitimacy to the hawks by showing that the Fed was not necessarily predisposed to lower rates.
As of this writing, Fed fund futures are not pricing in rate cuts for this year or the first quarter of 2027. There is a higher wager of a rate hike later this year, although the expectation has dropped on the heels of a weaker-than-expected June employment report. Contracts are targeting about a 24% likelihood of a 25-basis point rate increase at this month's policy meeting. I suspect the Central Bank will again hold the target range of 3.5%-3.75% at this month's gathering and my personal viewpoint supports no action.
A 43% probability of a rate hike is given for the September 15-16 meeting, which will release a new SEP. Prospects for tightening later this year have kept front-end Treasury yields elevated, while longer benchmarks have retreated. The current repricing for a higher-for-longer bias stands in stark contrast to the expectations of multiple rate cuts communicated by the futures in February.
By most accounts, it appears that Chair Warsh expects to dial back on forward guidance and general messaging as a way to preserve central bank flexibility and clarity, and reduce market dependency and unnecessary volatility. There is even a question over the future cadence of post-meeting press conferences and the SEP.
My personal view as an analyst and market strategist calls for as much transparency as possible. My concern is the markets could react negatively and more abruptly to a "quiet" Fed chair. Moving forward, I would be curious to see how the task forces suggested by the chair come together and how they can realistically add value.
With this in mind, we know that committee members enjoy the spotlight and often hold court on their own, offering up specific views on policy and economic conditions outside of the blackout periods. Further, there are enough formally written policy communications and surveys that would fill in the blanks, if necessary. Thus, I question whether a Warsh Fed actually moves closer to thinner messaging even though a new communications framework may be in place by yearend.
Messaging aside, Warsh and Fed participants will certainly focus a wide lens on geopolitical developments and prioritize trend developments rather than overly fixate on individual data points. At last month's policy meeting, 18 out of 19 participants provided "dots", with Warsh choosing to refrain. Looking at the Summary of Economic Projections released last month, the views on the funds rate are evenly split for 2026. Half of the participants think rates should be lower, while half call for higher rates.
For this year, the median federal funds rate projection now stands at 3.8%, versus 3.4% anticipated at the March meeting. For 2027 and 2028, a somewhat easier policy bias is anticipated compared to 2026, but with rates still higher versus the March projection. The Summary of Economic Projections show core PCE inflation running ahead of March projections through 2028, and GDP growth closely tracking the March outlook for 2027 and 2028.
By the end of the first half, we did see a flattening pattern emerge in the muni market similar to what I described for Treasuries, but munis remained comparatively stable, with limited selling pressure. Although March posted the worst muni monthly returns in over two years, green flashed proudly throughout Q2. April's strong rebound coupled with May and June positive returns placed the March month-end year-to-date performance deficit in the rear-view mirror, and positioned the broad market index for solid single-digit returns at yearend.
All of the muni stars lined up with favorable credit conditions, yield and income opportunities, a well-matched supply/demand dynamic, with a strong reinvestment cycle and healthy, yet uneven, fund flows, and good enough relative value to drive solid performance.
At half-time, munis were the performance star, marching to their own technical drummer and managing to insulate themselves from the geopolitical saga. Munis returned 96 basis points in June, finishing the first half at 2.32% and outperforming the 28 basis points of return booked by U.S.Treasuries both for June and year-to-date. For the same time periods, corporates earned 19 basis points and 86 basis points, respectively. Munis also outperformed the U.S. total fixed income market returns of 23 basis points and 83 basis points for June and year-to-date, respectively.
Parsing the Bloomberg performance data for June, quality attribution was more evenly allocated across the rating cohorts versus May's quality performance, significantly favoring lower-quality buckets. Nevertheless, "Baa" and high yield were well-rewarded last month. The value of tax-exemption, particularly when considering the compelling taxable equivalent yields, clearly resonated with investors.
Recognition of the relative steepness of the muni yield curve continued to promote duration extensions despite the sharp volatility and uncertainty, with the asset class providing reliable portfolio ballast and solid yield and income opportunities, especially from spread products.
Longer duration munis outperformed the curve last month, with the 20 year (17-22) and long bond (22-plus) buckets showing the best returns of 1.53% and 1.76%, respectively. Again, investors were motivated to capture the benefits of a steep yield curve by locking in additional yield at a time of relatively easing — yet still very much present — geopolitical concerns. Throughout June, the 10-year benchmark yield traded in a much tighter range compared to the 30-year, which demonstrated greater volatility. It was this volatility that allowed for more substantive spread tightening.
I would point out that ongoing SMA interest throughout the short to intermediate sectors helped stabilize yields and promote liquidity within these duration buckets. Longer duration munis remained more sensitive to like-maturity Treasuries, reacting to evolving macro conditions. Banks and insurance companies, which are typically long-end buyers, have been visibly scaling back their muni participation. This has removed some liquidity from the long-end and contributed to the relative instability.
However, new entry-point opportunities were made available for those buyers willing to venture out on the curve. Top tax bracket investors were given something else to consider away from equities, especially when assessing taxable equivalent yields for certain spots on the curve.
The more pronounced outperformance for lower quality credits was largely due to greater spread compression and higher "carry" attribution during June.
Better relative value opportunities amid a somewhat more expensive environment across the broader muni market — thanks to robust reinvestment and manageable new issue supply — created enticing yields for those investors willing to migrate down the quality curve. These investors were compensated for their higher risk tolerance.
The taxable muni index underperformed the broader tax-exempt index in June because spread tightening was more pronounced across the tax-exempt sphere given stronger performance for lower quality investment grade tax-exempts. Further, the tighter correlation between taxable munis and Treasury securities limited the upside potential for taxable munis given the less insulated volatility from macro and geopolitical developments.
Muni high yields outperformed the broader index in June. A still favorable credit climate and disproportionate spread tightening within lower quality buckets drove outsized returns. I would point out there is often greater spread to recover for the high yield sector during periods of sharp yield movements.
Muni credit was not penalized during June, but greater distinctions may emerge after the summer reinvestment season. While overall credit quality remains favorable, cracks within the veneer for certain sectors are growing deeper and, as expected, the upgrade/downgrade ratio has tightened considerably. I continue to worry about the healthcare, higher education, and K-12 sectors as well as certain pockets of local government credit. The rise in data center infrastructure needs will continue to pressure water and electric utility resources, with anticipated implications for muni credit.
The muni high yield index returned 1.33% in June, with year-to-date (June month end) performance of 4.09%. Certain high yield revenue bond sectors, such as hospitals and housing, outperformed the broader high yield index last month as credit concerns eased and investors identified spread tightening opportunities.
So far this year, reinvestment needs have been satisfied and I expect a continued appetite to meet maturing securities, redemptions, and coupon payments. Perhaps new issue activity will be challenged to accommodate this heavy demand, but I do not see a meaningful shift in the supply/demand dynamic.
Throughout June, flows into municipal bond mutual funds and ETFs were strong, but significantly trailed May's flows. I suspect that somewhat richer ratios and seasonal cash flow dynamics in June, and more compelling entry points in May, as well as greater Treasury market volatility last month, led to lighter fund flows. In my view, June was framed by selective allocations while May experienced a broader buy-in.
LSEG reports aggregate June inflows of about $3.85 billion, and year-to-date well exceeding $40 billion. Interestingly, active flows were visible during times of significant market volatility. I expect that continued constructive seasonal reinvestment will support the currently strong flow environment. Of course, the flow trajectory could be exposed to disruptive forces that even favorable technicals may not be able to offset.
Opportunities can be captured at a time when municipal credit quality demonstrates resiliency. Of course, active security selection is advised given noted cracks in the credit veneer. Although states enjoy strong "rainy-day" funds, there is likely to be downward pressure on those resources given declining support from the federal government, elevated inflationary conditions, heavy infrastructure investment needs, and evaporated COVID-era stimulus money. Certain revenue bond sectors, such as healthcare and higher education, are facing challenges given pricing pressure, constrained balance sheets, tighter operating margins, and competitive headwinds.
Issuance is on track for another record year. We have already seen several revisions to earlier supply estimates, some higher, some lower. Elevated rates can significantly alter the economics for refunding transactions, but this dynamic can shift very quickly. According to LSEG data, issuance was just under $300 billion through the first half of 2026, up 5.2% year-over-year.
Looking at the year-to-date volume figures, we see that issuers are accessing the market despite the volatility and higher rates. Issuers are likely to remain engaged, given their enormous funding needs and committed issuance schedules. However, ongoing volatility can place certain issuers on day-to-day status, or result in a downsizing of the deal or even a complete cancellation of certain transactions.
In this environment, many deals are being priced to sell and dealers are working hard to limit their balance-sheet exposure. More expensive ratios — with associated lower relative borrowing costs — can be a motivating force behind issuance. In these instances, greater concession is not often required to clear the market. Even spread-sensitive credits can enter at these ratio levels.
In conclusion, duration management should be used as an effective tool. As I pointed out, duration extensions with minimal credit risk can make sense for many investors, and we are seeing this with SMA buyers. However, a more conservative approach may call for a reduction in duration exposure until the geopolitical uncertainty abates. Not to belabor the point, but careful security selection, strategic allocations and active portfolio surveillance can go a long way toward achieving stronger returns.
