Municipal Insights 2nd Quarter 2025
The “Art” of the Deal
Art is subjective and “progress” may depend on your vantage point and bias. President Trump entered office in Q1 and a veritable blitzkrieg of policies and global trade changes have been proposed and unleashed. Last quarter we offered that we were heading into an unknowable landscape and that increasing the borrowing cost of the “risk-free” U.S. Treasury yield is a reasonable market reaction. We went so far as to suggest the mix of anticipated changes could result in inflation or even stagflation. Based on recently released Fed meeting notes, the Fed is concerned about the prospects for stagflation. Tariffs are generally thought to result in inflationary pressures while slowing global growth. With that said, tariffs generally hurt the country that is in the trade surplus position as compared to the country in the trade deficit position. Leading up to April 2nd (“Liberation Day”), when President Trump announced tariffs on many of our major trading partners, it was expected that the announced tariffs would amount to roughly 10%. When the President hauled out his tariff tote board, he shocked the world with rates ranging from 10% to 49%. For perspective, average U.S. tariff rates had been approximately 2.2% in 2024 according to the Richmond Federal Reserve Bank. The same study indicated that the average tariff among World Trade Organization (WTO) member countries is approximately 2.5%. The market seemed to be prepared for something on the order of 10%, but as informed readers may know the first volley of this trade renegotiation started at something well above expectations. As it is central to our outlook and forecasts, we will revisit this dizzying topic later in this piece, but we will be forced to continue to wade in the murky waters of the unknowable, in doing so.
Whereas tariffs grabbed much of the oxygen as of late, the start of the 47th president’s term was marked by immigration headlines and the cost saving efforts promoted by the Department of Government Efficiency (DOGE). We try to avoid being political in this Insights publication, so our intent with addressing these developments is through the lens of how we anticipate the changes will impact the economy and bond market. Border crossings have nearly stopped so the growth of the workforce should slow. In isolation that may result in wage pressure for lower wage positions. The efforts of DOGE have uncovered surprising purposes for which funds are dispensed, but the actual cost savings have been modest. As of April 8th, the DOGE official website shows an estimated savings of $150 billion. To hit the $2 trillion cost saving estimate originally offered by Elon Musk seems next to impossible. Republicans narrowly passed the blueprint for the budget, although it may be the case that a full continuation of the tax cuts for the higher-bracket taxpayers may be required to “make a deal.” This is relevant because the modest DOGE cost cutting will require a commensurate reduction in the continuation of some of the tax cuts to achieve President Trump’s and Treasury Secretary Scott Besset’s goals of reducing the deficit to 3% of GDP. The conservative lawmakers needed to pass the budget blueprint have been assured that there will be $1.5 trillion in savings while preserving essential programs. According to taxfoundation.org, using 2022 tax year data, the top 10% of earners paid approximately 72% of all income taxes collected. The savings needed to achieve Republican’s stated goals will need to come from the segment of the population that pays the most meaningful amount of the tax burden. Since Republicans used “current policy baseline” which treats an extension of the 2017 Tax Cuts and Jobs Act tax cuts as a continuation of law, it magically cuts $3.8 trillion from the proposed budget’s price tag. The Committee for a Responsible Federal Budget estimates the Senate’s plan would add at least $5.8 trillion to the federal deficit over the next ten years. The DOGE spending cuts will likely be a drag on growth, while the continuation of deficit spending may have the impact of dragging Treasury borrowing costs higher.
"Markets tend to like certainty, or the illusion of certainty."
Last quarter we spent a significant amount of time on the idea that many markets were priced for perfection. We have quickly found ourselves in a market that is very imperfect. Markets tend to like certainty, or the illusion of certainty. The style of U.S. communications has resulted in much change and uncertainty over the past couple of months. Germany has decided to increase defense spending by more than $1 trillion, which may be a sign that they would like to be in a position to not rely on U.S. military presence in the region. The “shock and awe” tariff announcements, along with the “on again” and “off again” start dates for the tariffs have rocked financial markets. On April 7, Treasury Secretary Besset indicated the tariffs are policy rather than a negotiation, and that it is “Main Street’s” turn to thrive, only to announce that a 90-day pause for the tariffs on all countries except for China two days later was a part of President Trump’s plan (which was very helpful for Wall Street). It may be brilliant to negotiate while the world is off balance, but it may have lasting unintended consequences for a country that plans to run deficits for the foreseeable future. Currently, the “art” of this deal looks more like a work from Pablo Picasso or Jackson Pollock. Let’s hope it’s our lack of vision and a “Michelangelo” comes out on the other side. We would consider a modest deficit, decent growth, opportunities for laborers of all skill levels, and a bit more calmness to be a masterpiece.
Over the course of the quarter, 10-year Treasury yields decreased from 4.57% to 4.2% and 10-year high quality municipal yields rose from a yield of 3.12% to a yield of 3.2% as the quarter ended. Taxable bond indexes experienced total returns of between 2.8% to 3.1% and municipal bond indexes experienced total returns of between 0.5% and 0.9% for the quarter. Since the end of the quarter, our safe haven status may be in question, or concerns about the degree of deficit spending have been the likely cause of an increase in 10-year Treasury yields. Corporate bond risk spreads have widened, putting related bond values under pressure. Sadly, even the sleepy backwater of the municipal bond market saw the worst single day losses in 30 years, only to mostly recover a couple days later. Uncertainty seems like it will be the constant in the world. The USMCA agreement took the better part of three years to negotiate and finalize. We may find moments that feel normal, only to have the rug pulled out from under us. Let’s hope our trading partners and the markets have the patience to get to “the deal.” If not, the dollarized world economy may be in for change “like we’ve never seen before.”
Q2 Interest Rate Outlook – The Fed Fears Stagflation
According to the Richmond Fed study referenced earlier, research indicates that each 10 percent increase in tariffs generally raises producer prices by one percent and it translates to roughly a 0.3% increase in the consumer price index (CPI). A 2019 working paper found that tariffs generated $51 billion in losses for consumers and firms that depend on imported goods, though if you factor job gains in protected industries the net loss to the economy was $7.2 billion, or 0.04% of GDP. The conclusion of the Richmond Fed paper was that the economic effects of the 2018-2019 tariffs were a net negative for the economy. As it related to the current tariff discussion, the paper models four separate scenarios, ranging from an Average Effective Tariff Rate (AETR) of 7.1% to 17%. We expect this Fed study, along with the economics 101 concept of comparative advantage is the basis for both the Fed and many people to think that tariffs will result in slower growth and inflationary pressures at the same time. It wasn’t long ago when we were fearful of having to entirely rely on other countries for personal protective equipment, pharmaceuticals, and semi-conductor chips during the pandemic. Hopefully president Trump’s vision isn’t to make socks in the U.S. but that there is a view to make value-added goods like semi-conductors, cars, medical devices and pharmaceutical drugs in the U.S. The “forgotten consumer” mentioned last quarter may get some source of utility from onshoring crucial industries. Although many people have determined the Trump approach to trade negotiation is a major policy blunder, it continues to feel like a forgivable episode. In other words, if there is a misstep, this feels like a situation where the Trump administration can reverse course to a degree. If, in fact, there are lopsided trade agreements, then pursuing fair or more equal terms is seemingly a defensible position. Depending on the media you consume, the trade negotiations are the best, or worst, policy steps the U.S has made in decades. Absent a financial institution failing due to higher yields and widening spreads or segments of the capital markets freezing, this feels like an episode that offers a retreat (with egg on our face) if needed and a possible “win” for U.S. taxpayers and workers in some strategically desirable segments of the economy.
Prior to recent inflation data, it seemed as if the Fed would be nearly immediately in the position of having to choose between allowing inflation to run hotter than their stated goal of 2% or having to preventatively support the employment environment. Recent inflation reports have shown an uptick and at the same time consumer sentiment is cratering and long-term inflation expectations are near a 30-year high. Although the unemployment rate moved slightly higher, to 4.1%, historically, that is essentially “full employment.” The Fed’s “Sophie’s Choice” that is being bantered about seems to be less agonizing than the market indicates. De-globalization and friend-shoring were going to create some inefficiencies but with that, the risk of supply shocks is diminished. The changes and inefficiencies of using tariffs feels like it is an extension of the changing location of production, with the added benefit of continued support of full employment, economic activity, possibly the multiplier effect at work, and the benefits of research and development that accrues to the benefit of the U.S. (understanding that current efficiencies theoretically offer the ability for savings and investment that could have similar benefits). Given the current 90-day pause of the implementation of tariffs for all countries except for China, the Fed’s most likely path is to leave policy unchanged, which is to say slightly restrictive, until employment measures deteriorate. If capital markets are functioning in an orderly way and borrowing costs remain in check, the Fed will take its direction from the labor market. Recent CPI numbers produced a month-over-month decline that was the largest since June of 2020. Headline CPI fell 0.1% when expectations were for an increase of 0.1% on a month-over-month basis and core CPI was up 0.1% on a month-over-month basis when expectations were for growth of 0.3%. On a year-over-year basis, the CPI headline is growing by 2.4% and core CPI is growing at a pace of 2.8%. Since the 25-year average 12-month CPI is 2.5% (Source: Bloomberg), we think the Fed would be prudent to maintain their slightly restrictive policy stance, given that inflation is effectively “average” and the labor market is tight by historical standards. If cracks in market liquidity emerge, the Fed will obviously step in and change course.
"Relative to GDP, it feels like spending is the side of the equation that must make the largest move..."
There has been a lot of consternation caused by the polarized political environment. Specifically, there has been a public debate between Republicans who say we have a spending problem, and Democrats who often say we have a “paying for” problem. According to a report issued on May 20, 2024, from the non-partisan Tax Policy Center, in the post WWII era, revenue as a percentage of GDP has been roughly 17.18%, while average outlays as a percentage of GDP approximate 19.716%. Their estimate for 2024 was that revenue would approximate 18.0% of GDP and spending would be 24.6%. Treasury.org places the 2024 spending level as a percentage of GDP at 23%. Relative to GDP, it feels like spending is the side of the equation that must make the largest move toward historical averages to have a more balanced budget. Coming off the needed and elective spending related to the pandemic, it makes sense that spending would need to revert to something “normal” and it is also predictable that the return to normal would be celebrated by some people and feared by others.
The tariff situation has been so fluid that it is daunting to start to form an opinion about it, much less putting something on paper that won’t be in readers’ hands until the last half of April. Just this week, Goldman Sachs made a forecast for a recession, only to retract that call on the same day. The White House’s goals appear to be to raise revenue, support “American jobs”, and seemingly there is a goal of having fairer, or more favorable trade terms. In the end, it is a tax on consumption. Some of the burden may fall on companies that export to the U.S., retailers and purveyors may wear some of the cost, and consumers will likely bear a portion of the burden. As a consumption tax, depending on what the final landscape looks like, it may be a regressive tax that places a comparatively large part of the cost on lower income people (from a percentage of disposable income standpoint). Said differently, you could see it as broadening the base of taxpayers. The Covid stimulus dollars taught us that money in the hands of lower income people is more likely to be spent than is the case for higher income earners. By extension, the velocity of money in the hands of lower income people may be greater than it is for high income people. The gamble that we appear to be making is that although lower income people will bear much the short-term burden, longer term their job prospects and future wages will make up for the short-term pain. Although we don’t know the outcome of this wager, we can look to history for some similar events as a guide to how this may go. As mentioned, tariffs are essentially a consumption tax. Japan has had three major consumption tax hikes that occurred in 1997, 2014, and 2019. We are already hearing importers racing to fill warehouses ahead of the tariff hikes. Not surprisingly, just ahead of the three hikes in Japan, consumption ramped up and then fell meaningfully after the tax was enacted. It may be related to demographics or somewhat attributable to the consumption tax, but household spending in Japan still hasn’t recovered to the levels preceding the 2014 hike. We find it interesting that comparatively, a consumption tax may be a bigger deal in the U.S. According to Bloomberg, 69% of U.S. GDP is related to consumption, whereas only 53% of Japan’s economy is based on consumption. Changing the dynamics of consumption in our economy seems like it will have major implications (to state the obvious). If we borrow from the three Japanese experiences, the shortest time to recovery, where consumption returned to pre-tax-hike levels was 45 months, following the 1997 change. Political realities suggest that we don’t have the appetite for “short-term” pain of 45 months. We interpret this to say that consumption will accelerate in the short run and fall off once the tariffs are really real this time for sure (with no changing our mind, most likely).
"We can spin our head on the bat as well as anybody, but in the end, much of this is self-governing."
It is believed that the U.S. Treasury market move caused President Trump to blink and pause the tariffs for all countries except for China. Earlier in April, Treasury yields fell on the assumption that growth would slow and that the inflationary pressures caused by tariffs would be more of a one-time price hike, rather than a trend toward higher rates of inflation. As the risk of a global trade war increased, it may be the case that the U.S. Treasury status of being a safe haven asset was being called into question. It may also be the case that our trading partners were looking at decreased trade activity and the need to buy Treasuries with dollar-denominated trade proceeds. It is also possible that foreign countries were selling Treasuries in protest of the approach or content of this negotiation. We can spin our head on the bat as well as anybody, but in the end, much of this is self-governing. If borrowing costs get too high, financing costs will result in slowing sales activity, the housing market will slow, and decreased economic activity should depress inflation expectations. Stagflation is something to fear, but this episode feels like it is self-inflicted and if things go too poorly, we can largely go back through the door from which we just came (meaning revert to the old policies and changing the political landscape). The Fed has largely ended its Quantitative Tightening program and flipping the switch to a Quantitative Easing program should be able to address shocks to the Treasury buying universe. The Fed has several programs to inject liquidity into the financial system if needed. One thing we don’t anticipate is for the Fed to simply step in due to a general feeling of uncertainty. A liquidity shock or eroding employment numbers are the challenges we would expect in order for the Fed to change their policy stance in short order.
At the time of the writing of this piece, the U.S. 10-year Treasury yield sits at nearly 4.5%. Higher for longer seems like it will hold for much of this year, especially with the spending expectations for other safe haven sovereigns. If 10-year Treasuries break out above 5% it would seem we will test a level between closer to 5.5% and the floor we are now forecasting is 3.5%. We continue to think U.S. Treasury rates will depend on expectations for fiscal discipline and we expect that Treasuries will benefit from “flight to quality” events where Treasury yields fall in the face of volatility and uncertainty. At the current time, there really isn’t any alternative.
Municipal Market Developments – Worst Day in 30 Years
The first full week of April saw that municipal bond yields were not exempt from the “risk off” feel that swept the markets. Yields rose nearly 60 basis points over the first couple of days of the week. We are starting to think that investor use of ETFs for an asset class that is subject to liquidity swings is going to add to the volatility of the market, like never before. Muni bond funds saw more than $3 billion in outflows. Municipal bonds experienced the largest single day decline in 31 years. The amount of municipal bonds out for the bid on Bloomberg’s platform topped $3 billion, the most since at least October of 2022. The good news, if even temporary, munis also had one of their strongest days on Thursday, with some yields falling nearly 50 basis points. Munis clearly were not immune to the wave of fear that rocked the markets this past week. They mirrored some of the price volatility that is more customary in the stock market. Seeing price movements of nearly 3% in a day on a municipal bond is unusual, and almost unheard of for bonds. As of late, that might be a quiet day in the stock market.
As discussed earlier, the DOGE efforts, along with general taxing and spending goals, increase the possibility that the municipal bond market will be caught up in the conversation. Last quarter we addressed the discussion about changing the tax exemption of municipal bonds. Some twists on that involve a cap on the amount of tax-exempt income an investor can earn from municipal bonds. Counter to the cost saving efforts, the talk of reducing the corporate tax rate would likely impact the value of municipal bonds by further reducing the taxable equivalent yield benefits that municipal bonds offer to a large group of municipal bond buyers. Insurance companies and banks have historically been large buyers of munis. The lower the corporate tax rate, the less of a benefit this group of buyers derives from holding municipal bonds. Whether it is limiting the amount of tax-free income individuals can claim, or reducing the corporate tax rate, it seems munis will have headwinds until fiscal policy is understood. Other policies involving the municipal market changes and the budget debate will impact higher education institutions. Part of the current discussion involves taking the tax-exempt status away from private non-profit universities and increasing the endowment tax on wealthy universities, those with endowments greater than $500,000 per student, to something above the current level of 1.4%. The operating environment for colleges and universities has been challenging, although the recent lull in enrollment may be subsiding, so a net increase in costs may put these institutions under greater stress. There are many potential developments swirling around the municipal market. In the end many of the proposals don’t save any material money, they just push costs to another unit of government. What is a common thread is that the changes are significant to the related issuers and until alternative sources of funding and financing are established, the environment is uncertain.
"We avoid credits that we feel are exposed to the competitive nature of a market."
Finally, as it relates to munis, the headlines in the municipal bond market and concerns about the many sources of flux dictate that we revisit the basis for ACG’s Essential Purpose municipal bond portfolio management philosophy. In short, we buy bonds from issuers we deem to be of an essential nature, those who serve the basic needs of the population. We avoid credits that we feel are exposed to the competitive nature of a market. Default studies throughout the years have supported the idea that the populace will pay to have drinking water, schools, and sewage treatment. In challenging times, people are less likely to support elective payments on a minor league baseball park, a convention center, or the world’s largest ball of twine museum. ACG’s credit process involves looking past any bond insurance or credit enhancement to the quality of the underlying issuer and project. We see insurance and enhancement as a liquidity enhancement, and by looking to the quality of the issuer, we feel that part of our process builds in a degree of conservatism to our portfolio construction process. In volatile times like the start of April, our experience is that clients appreciate the added layer of quality and the makeup of the issuers to which they are making loans. At the highest level, our approach has kept us away from dangerous market fads, and projects that are better served through bank financing or other financing options that are higher touch than the municipal bond market. Recently a recycling plant in Indiana missed a payment on a $170 million issue and the bonds traded in February at 16 cents on the dollar. Currently more than 10 percent of the “green” industrial development bonds are in default. An Arizona sports complex that never had enough revenue to cover their first bond payment looks like it will cost bondholders $280 million, with a recovery of approximately 1%. Circling back to drinking water and sewage, people tend to like adequate capacity in both services, so they are often willing to do anything in the realm of reasonableness to keep things flowing. Fraud and lack of proper accounting controls can occur anywhere, but our observation is that it is most often found in unproven areas that are subject to the competitive pressures of a marketplace, or that address changing population preferences.
Strategy and Summary – Driftless, Get Used to It
Our “Michelangelo” may have been the strategy offered last quarter. We said it was liberating to embrace the reality that we don’t know what the future holds and of the two paths we could envision for the economy the upcoming tariff policy could stoke inflation and would likely drive bond yields higher. We were also of the mind that productivity gains or wage improvement would appear for the next couple of years. It is feeling like the outcome of the trade negotiations will most likely be some form of revenue generated from tariffs and that the reality of improving the job prospects for low and moderate workers will be in the out years. It may be that the Trump administration can use the revenue gains to pay for immediate measures to stimulate business investment. Accelerated depreciation and other corporate tax breaks may help workers sooner than the construction of entirely new factories, but it may also get factories built faster than if they weren’t offered. The banter about the world moving away from the U.S. Treasury as the backbone of the world economy is likely bluster and posturing in this Trumpian negotiating environment. There isn’t currently a viable alternative. That is not to say U.S. dollar hegemony and the unique position of U.S. Treasuries is an advantage that should be toyed with lightly. It is just that it seems this line of concern is ripe for reversal. When the next financial institution has a brush with failure, or if one of the many global “hot spots” sees war break out, watch the value of U.S. Treasuries.
From a strategy standpoint, the Fed seems to be on hold until the last half of 2025. The U.S. economy is at full employment and headline inflation between the 25-year average and the Fed’s stated goal of 2%. In a vacuum this is an economy the Fed should like. An ever-changing tariff policy doesn’t seem like it will spiral into a trend of higher inflation. It feels like it will be a jump in costs which will be shouldered by many entities in the trade equation, so the inflation impact may be somewhat muted. As mentioned earlier, as a consumption tax, it may have the near-term influence of accelerating consumption and creating a lull on the other side of the enactment. Short-term bonds continue to be a stabilizing part of our barbell strategy. Cash equivalents and short-term bonds offer a historically attractive yield. On the other side of the barbell, we like high quality issues spread throughout the 5-year to the 10-year part of the curve. That piece of the strategy could benefit in a couple of scenarios. First, if the conversation about the safety of U.S. assets subsides, or if a dramatic world event occurs, we think people are creatures of habit and the U.S. Treasury will regain its safe haven status. Additionally, if the forgotten consumer displays their exhaustion, the economy will slow, and the longer segment of the barbell strategy should see some appreciation. A common thread throughout this quarter’s strategy is “uncertainty.” Against that backdrop we recommend a focus on quality. Yields are historically high, why not capture most of the benefit without the sleepless nights. The pace, tone, and approach to global trade policy along with the broader investment market volatility are already taking up too much mental shelf space.
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