In a previous SMC FIM commentary, we attempted to debunk the “market timing” myth and presented evidence that showed investors actually lose valuable tax-exempt income by not maintaining a fully invested bond posture. This month we challenge the veracity of another widely held market myth:
“Fed short-term interest rate tightening results in equivalent higher long-term interest rates”
Many investors mistakenly assume that short-term and long-term interest rate movements are linked through comparable yield movements. However, history disproves this notion.
- During the last extended period of Fed rate tightening (2004-2006), the Federal Funds rate increased by 425 basis points; however, the 10-year U.S. Treasury yield experienced an increase of only 50 basis points.
- During this time period, municipal bond yields, as measured by the Bond Buyer 20-Bond Municipal Bond Index, actually declined by 27 basis points. Historically, the movement in tax-exempt bond yields generally fails to match that of Treasury or comparable corporate securities.
We believe there is a good chance that history will repeat itself during the current phase of short-term rate increases. Why?
- First, think about what long-term interest rates reflect: the expectation of future short-term rates plus a risk premium – the extra compensation for owning a security that will not pay off until sometime in the future. Investors should be paid for market uncertainty. Investing in U.S. Treasury securities does not present any credit risk, so the major risk factor is inflation.
- As reflected by current bond interest rates, the threat of inflation continues to be constrained. Lack of significant inflation pressure should continue to subdue any meaningful rise in intermediate-term and long-term bond yields, even as short-term interest rates are managed higher by the Fed.
- The goal under the current Fed program is to normalize interest rates and not to stem an imminent inflation threat. Today’s program is without historical precedent. So, the impact on long-term interest rates this time could be even more muted than what has happened in the past, causing a further flattening of the yield curve.
- The impact within the municipal market is already being reflected in a flatter yield curve. We believe this is due in part to the significant reduction in net new tax-exempt bond issuance and an increase in retail demand due to changes to the individual income tax code such as the elimination of greater than $10,000 of SALT deductibility.
SMC Fixed Income Management (SMC FIM) is a municipal bond advisor and manager that provides customized municipal portfolios for individuals, trusts and estates through its Separately Managed Account Program, and provides advisory services to Unit Investment Trusts.
The information provided in this commentary is not intended to be a complete summary of all available data. Certain information contained herein has been obtained from published sources and/or prepared by sources outside SMC Fixed Income Management (“SMC FIM”), a division of Spring Mountain Capital, LP, and certain information contained herein may not be updated through the date hereof. While such sources are believed to be reliable, no representations are made as to the accuracy or completeness thereof by SMC FIM or any of its affiliates, directors, officers, employees, partners, members or shareholders, and none of the former assumes any responsibility for the accuracy or completeness of such information. Nothing contained herein shall be relied upon as a promise or representation as to past or future performance.
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