Muni leaders surprised by aggressive rate cut

A larger than expected federal funds rate cut on Wednesday caught a lot of market experts off guard.

"I was surprised by the size of the cut," said Vikram Rai, head of municipal markets strategy for Wells Fargo (WFC). "I was expecting 25 basis points, but you can rationalize 25 or 50. Muni investors have waited for this, now they want to see the cash that has built up on the sidelines."

The comments came on Thursday during a webinar produced by the Volcker Alliance and the University of Pennsylvania Institute for Urban Research.

Rai is expecting two weeks of market volatility caused by the Federal Reserve's move. He also officially declared that two years of an inverted Treasury bond yield curve is over, which may fuel more higher inflows of funds into the municipal bond market.

The yield curve compares yields paid on 10 and two-year Treasury bonds. If the two-year rate is higher than the 10-year, the curve is designated as inverted, which portends a looming recession. The curve has remained un-inverted since Sept. 6.

"There is about $5 trillion of cash and cash equivalents that have built up on household balance sheets," said Rai.

"The question is, will this cash flow into low-income investments, and correspondingly, will we see some of this flow into municipals? This cash flow to municipals will drive down bond prices and bring down the financing costs for state local governments."

The funding that supports many state and local governments has been a roller coaster ride with the highs caused by upticks in tax revenue fueled by consumer spending during the pandemic, combined with federal stimulus funds.

Reserve funds fattened as several states cut their income taxes or issued refunds. As federal funds began running out, many experts were pointing to a looming fiscal cliff.

Mark Zandi, chief economist for Moody's Analytics, believes the borrowing rates for states and municipalities have stabilized.

"I think generally rates are still elevated, but mostly on the short end," he said. "In the intermediate and longer range they're roughly where you'd expect them to be. The 10-year treasury yields at 3.75% last night. I wouldn't count on that going any lower. if you're in the intermediate or longer-term parts of the bond market, this is it."

The effects of a possible government shutdown scheduled for the end of September barring Congressional action is emerging as a speed bump on the highway of economic good news and stability.

"That is very distressing," said Rai. "State and local governments, need to brace for a possible curtailment on the federal funding. Local governments need to spend their dollars first and then they're reimbursed by federal agencies anticipating receipts."

The outcome of the upcoming election is expected to affect state and local governments as federal tax policy will be scrutinized. On Tuesday former President Trump hinted at lifting the deduction cap on state and local taxes, which was part of the Tax Cuts and Jobs Act that he championed while in office.

Rai is predicting the SALT cap deduction will remain in place no matter who wins in November. He also reiterated his position that disagrees with analysis showing the deduction cap as a moneymaker for the federal government.

"I published a report on how the cap on the SALT reduction actually costs the federal government dollars," he said. "The state and local tax collections have gone up because of various legislations that have gone into place. And corporate tax collections of the state of New York, the state of New Jersey have gone up because of a capital salt reduction."

Zandi also addressed the divergent views on economic conditions as viewed from the two sides of the political fence. "People are looking at the economy through their own political prism" he said. "Thinking about how the economy is performing objectively, this economy is performing very, very well."