The Federal Reserve Board is on a mission to fight inflation, but municipal bond investors should think twice about what it means to them.
After scraping historic lows, the Fed has raised rates four times so far this year. In March it bumped rates by 25 basis points, the first hike in four years. Since then, the Fed has been more aggressive, initiating hikes of 50 basis points in May and 75 basis points in both June and July.
Some investors interpret these increases as a sign the economy is roaring and long-term interest rates will spike.
That’s where we advise caution.
Inverted yield curve
The Fed can only set the federal funds rate. That’s the interest rate banks charge each other to lend overnight. In other words, it’s the shortest of interest rates.
Municipal bond investors, on the other hand, focus on long-term rates, which are determined mainly by the buying and selling of municipal bonds.
When the Fed raises rates, it’s trying to slow the economy in order to tame inflation.
We’re now seeing the results of those efforts – an inverted yield curve, which historically indicates a recession is on its way. In fact, according to the Federal Reserve Bank of San Francisco, every recession in the past 60 years was preceded by an inverted yield curve.
An inverted yield curve occurs when shorter-term Treasury yields are higher than longer-term yields. Recently, for example, the 10-year to 2-year spread was -.276%, the deepest inversion since 2000.
Waiting breeds disappointment
So what does this all mean?
Investors still holding on to their cash waiting for rates to soar are foregoing juicy yields available on municipal bonds now and will likely be disappointed later.
Earlier this year, some investors surrendered to fears over inflation and fled the market. They ignored the fact that the bonds themselves were healthy. Now, many are doing a U-turn and stampeding back into the market.
Experienced investors, on the other hand, not only stayed the course, but took advantage of attractive yields and added to their holdings (“For Steady Muni Investors, the Work Already Turned”).
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Don’t fight, or get fooled, by the Fed
In recent polls, most economists said the Fed will likely raise rates by 50 or 75 basis points next month. We don’t know and prefer not to guess. Avid Fed watchers who attempt to predict what, if anything, the central bank will do are never right for a sustained period of time.
It’s easy for investors to get buried by an avalanche of often conflicting conjecture that muddies what is otherwise a simple process in municipal bond investing.
Aim for quality first, then yield. Keep your steady stream of tax-free income flowing. Avoid trying to outguess the market or the Fed.
Remember, higher short-term rates usually lead to lower long-term rates as demand destruction accelerates and the economy slows.
An old axiom in the markets tells us not to fight the Fed, to which we would add, but don’t be fooled by it either.