With the December Fed meeting just around the corner, a fresh round of interest-rate guessing is upon us.
However, unlike previous bouts of overheated prognostications, a dollop of reality seems to be seeping into the discussion.
The economy, a long slow slog
Those clamoring for a rate hike will attempt to point to positive economic news. Although anemic, GDP improved to 2.1% in the third quarter, and the questionably calculated jobless rate fell in October to a seven-year low, while wages were up slightly in August and September.
But the recovery is still fragile. Commodity prices are severely depressed and inflation is virtually non-existent. And though the U.S. economy has pockets of growth, most U.S. trading partners are struggling.
China’s economy, an important engine for global growth, is slowing, while the European Central Bank is contemplating rate cuts and continuing its bond-buying program in an effort to shore up Europe’s own growth slump.
Flat yield curve
The important point for municipal bond investors in all of this is that a rate hike by the Fed doesn’t indicate fear of inflation, the traditional enemy of fixed-income investments.
As we have argued previously (most recently in “The Media’s Interest-rate Myth”), any move by the Fed to hike short-term interest rates in this economic environment will likely precipitate a flattening of the yield curve.
We were heartened to finally see a recent article in Barron’s recognizing that if the Fed does move on rates next month, short-term muni prices can be expected to fall as they did during the last period of rate hikes – from 2004 to 2006. During that period, long-term muni bond prices rose and yields declined. The long end of the yield curve is primarily driven by inflation expectations, which are currently non-existent.
Minimal effect
Although there is continuous debate on the merits of a quarter-point rate hike next month, almost all economists agree the bump will be minimal, as will be the impact on financial markets, and it’s assumed to be a one-and done.
“Wait-and-seers” – investors with cash parked on the sidelines waiting for long-term rates to rise – will be disappointed. The buy signal they’ve been waiting for will be supplanted by regret over the tax-free income they passed up and a failure to take advantage of the 4.00% tax-free yields available today on high quality municipal bonds.