By Ted Vogel, Portfolio Specialist, Municipal Fixed Income
"The income tax created more criminals than any other single act of government." - Barry Goldwater
Short to intermediate U.S. Treasury interest rates increased in the fourth quarter as market attention was focused on generally better-than-expected economic data releases and uncertainty surrounding the Trump administration's tax reform proposal. The rate movement was most pronounced in the front end of the yield curve, with the two-year U.S. Treasury note yield increasing from 1.49% to 1.92%, the five-year from 1.94% to 2.21% and the 10-year from 2.34% to 2.41%. The 30-year yield, however, declined to 2.74% from 2.87%, resulting in a flattening of the yield curve overall.
With regard to monetary policy, the Federal Open Market Committee (FOMC) voted to raise its benchmark interest rate to a range of 1.25-1.50% and to continue the process of balance sheet normalization which began in October. In a statement, the FOMC said its decision was largely based on the faster-than-expected growth in recent months and strong job creation. While policymakers also noted that inflation remains below their 2% target rate, they anticipate that a tightening labor market will eventually create the demand necessary to raise prices. Market attention now turns to 2018, when the FOMC's projections suggest three possible rate hikes for the year, with the market pricing a slightly better than 50% probability of the first increase in March.
Economic data in the U.S. continued to strengthen through December. The November employment report was mixed, with the change in non-farm payrolls exceeding expectations at +228,000 versus the anticipated +195,000, unemployment remaining unchanged at 4.1% and average hourly earnings growth of +0.2% falling short of +0.3% consensus. November headline inflation (Consumer Price Index, or CPI) was in line with expectations at +2.2% year over year, while core CPI came in at +1.7% year over year versus consensus of +1.8%. November retail sales surprised to the upside with a +0.8% month reading compared to +0.3% consensus, representing the third consecutive month above expectations.
The broad municipal bond market posted a +0.75% total return in the fourth quarter and a +5.45% return for the year, according to Bloomberg Barclays Municipal Index data. Returns were mixed across the yield curve, with negative performance on shorter maturities and positive returns on longer bonds. Price action was influenced by a large increase in new issue supply and the general upward movement in interest rates. With regard to sectors, revenue bonds outperformed both general obligation and pre-refunded bonds. As had been the case for most of the year, lower-rated bonds outperformed those with higher ratings.
Municipal bond issuance set a single-month record in December as issuers raced to complete deals before the Tax Cuts and Jobs Act of 2017 became law. It was thought that issuance of certain refunding and private activity bonds might be curtailed if included in the final version of the bill. New issue volume increased to $62.5 billion in 1,168 transactions from $20.8 billion in 780 deals in December 2016, representing an increase of over 200%. For the fourth quarter, supply was up 33.4%. For all of 2017, volume was approximately 3.4% lower than in 2016. The calendar was led by issuers from California, New York, Texas, Illinois and Pennsylvania.
Post-Election Issuance Bonanza
2017 Municipal Bond Issuance vs. Last 5 Years
Outlook: Rates and Technicals Trump Taxes
Given the pickup in economic growth in the latter part of 2017 and stable levels of inflation, we see no reason to doubt the FOMC's stated intention of several more interest rate hikes in 2018. That said, unexpected implications from recent tax code changes, potential volatility caused by the withdrawal of monetary policy accommodation by the FOMC and perhaps other central banks, and ongoing political rancor in Washington, D.C., might cause us to adjust our expectations.
Specific to the municipal market, technicals continue to look promising for 2018, in our opinion. Reduced new issue supply, courtesy of recent tax reform legislation, should help maintain a firm bid for municipal product. At this time, we believe that the modest reduction in top marginal tax brackets should have little impact on demand from most muni investors. We continue to track the progress on infrastructure spending proposals, but believe that several months may pass before any legislation impacting the muni market becomes a reality. We continue to favor a research-based, bottom-up investment approach as an effective way to find attractive buying opportunities for investors.
Lone Star Recovery Begins
Hurricane Harvey made landfall near Rockport, Texas, on August 25, 2017, as a Category 4 hurricane, causing record amounts of rainfall and damage across a large swath of Texas - from the border region of South Texas to Austin, to its eastern border with Louisiana. After an unfortunate loss of life, economic recovery has begun and will continue for many years. Damage estimates range from $75 billion (Moody's Analytics) to nearly $200 billion (CBER, Ball State University).
Still, while the estimates are large in absolute dollars, context is important. For example, the Greater Houston area1 had a GDP of $478.6 billion in 2016, ranking sixth among the nation's metropolitan areas even after previous declines in natural resources and minerals. Importantly, its unemployment rate (non-seasonally adjusted) dropped from 4.9% in the month prior to the storm to 4.1% as of October 2017, suggesting continued strengthening of its labor market. Already showing self-reliance in recovery efforts, the Texas economy will receive considerable help from outside sources: insurance proceeds, state aid and federal grants through the Federal Emergency Management Agency (FEMA).
- Ernest Gyasi, Senior Research Analyst, Municipal Fixed Income
1 Source: FRED Economic Data. Refers to the Houston-Woodlands-Sugar Land Metropolitan Statistical Area (MSA).
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