A supportive macro backdrop positions municipal bonds for a solid 2026

The 2025 municipal bond market overcame periods of market volatility and technical headwinds, which catalyzed yield and income opportunities for investors, and I expect munis to be a continued provider of investment ballast as the market navigates the rate and economic environment in 2026.

I'll kick off this column with some predictions for the coming year.

• In 2026, success will be defined by innovative thought leadership and financing solutions that touch virtually every fabric of the municipal bond community, and overall performance will be driven by net positive fund flows, a supportive rate environment, and favorable, yet challenged, credit conditions.

• Credit fundamentals should remain favorable over the foreseeable future, but sector-specific challenges are emerging, requiring greater levels of analytical rigor in 2026.

• The ratio of muni credit upgrades to downgrades will continue to tighten in 2026 with the likelihood of a more balanced relationship; state general obligation bonds and many local GOs can anchor portfolios given ample reserves and continued fiscal austerity.

• 2026 is expected to bring another year of record supply.

• Sub 5% muni returns are expected in 2026.

• Taxable munis are poised for another year of outperformance given lighter taxable issuance, yet the performance gap between the broader muni market and taxable munis could tighten depending upon the degree of interest rate declines and associated taxable issuance levels.

• More steepening momentum for the muni yield curve is anticipated in 2026, unlocking further income and duration opportunities.

• Muni ETF and SMA growth will continue in 2026.

• Central to my 2026 outlook, recession is not factored into my base case forecast. Above-trend growth with disinflationary conditions remains likely in 2026, but potential disruptors may present themselves and impede growth.

• Growth performance is visibly uneven throughout the regional economies and we are observing diverging employment trends across sectors and business lines, conditions supporting a K-shape economy in 2025, and likely to be evident in 2026.

• The Federal Reserve will not be on a predetermined course in 2026 as data dependency should guide policy.

• Inflation holds a low probability of reigniting, and so the Fed's easing trajectory should take on a preferably slow and steady course rather than an accelerated one that would normally be illustrative of a deep economic contraction.

• While I would argue against front-loading too many rate cuts, particularly given still-emerging tariff-related price increases for various goods as well as higher service sector costs, additional rate cuts than expected could come about should the labor market picture appreciably deteriorate and become more consequential than inflationary pressures.

• While consumer confidence and engagement have been showing signs of retrenchment, it remains my view that the U.S. consumer will continue to drive economic support, even into the next recessionary cycle.

• I suspect that U.S.Treasury yields will be range-bound until new data entrants tell us otherwise, and quite possibly longer tenor Treasury yields may be propped up due to inflationary concerns and Treasury supply pressure. Such movement of the 10-year may display little correlation with the downward course of short rates, thus further normalizing the steepness of the Treasury yield curve.

• Artificial Intelligence (AI) will impact all aspects of the economy, touching virtually every business vertical and reshaping and differentiating the views currently held by many public finance stakeholders.

• Moving forward, better clarity as to the role issuers will play in developing AI infrastructure, and just how much capital market access would be required, should emerge.

• The debate over AI data centers will take on greater political, societal, environmental, judicial (potentially), and funding overtones.

• The political debate will likely heat up in 2026 given the November mid-terms, and so I do not expect any new substantive fiscal policies having outsized spending priorities to emerge from Washington.

• My base case calls for a narrow Democratic majority in the House after the November election. Should the GOP retain a majority in the House, I would expect climate change initiatives, proposals for tax increases, and new regulatory oversight for businesses to stay out of that chamber's core agenda.

• Tariffs from a rebalancing of trade relationships remain embroiled in fits and starts without having clear messaging on GDP and inflation, and will likely present continued challenges for 2026, albeit less disruptive. The wild card would be an adverse decision coming from the U.S. Supreme Court, which could rule against President Trump's legal ability to impose sweeping tariffs under the International Emergency Economic Powers Act. Such a ruling could undermine growth expectations as well as create an operational and logistical nightmare should refunds have to be provided.

• The market can expect a broader application of P3 involvement fueled by natural disasters, aging infrastructure, traffic growth, and competition. Airports, mass transit, toll roads, bridges and tunnels, and the nation's power grid would all be major beneficiaries of infrastructure initiatives.

As the muni market bids goodbye to 2025, it does so with a sense of accomplishment and an outlook for guarded optimism into the new year. The 2025 public finance experience will leave an indelible mark upon the investor community as the market fired on all cylinders, albeit not without earlier knocks, given greater policy-driven stress points with accompanying underperformance, negative returns and inflated tax-exempt yields during the first half of the year. Arguably, uncertain fiscal policies often give rise to leadership and/or strategic inertia at the corporate as well as at the state and local governmental levels.

For the new year, success will be defined by innovative thought leadership and financing solutions that touch virtually every fabric of the municipal bond community, and continued demand for the asset class will be the key driver of 2026 municipal bond performance. 2025 set a record for volume, approximately $580 billion according to LSEG. While my supply forecast for 2026 will be revealed in the final installment, I will tease that I expect another record year for muni issuance.

The muni market enters 2026 with a strong outlook as highlights from 2025 are expected to continue. Credit quality remains favorable across most sectors, although it has plateaued with emerging cracks in the credit veneer likely to elevate challenges in 2026. Absolute yields and attractive cash flows provide a compelling argument to put sidelined cash to work in a tax-efficient manner, and market technicals should also buoy competitive returns. Taxable equivalent yield calculations make the value proposition that much more apparent.

Similar to much of 2025, the new year should experience manageable bid-wanted lists ? absent a major policy or credit event ?, comfortable dealer inventories, strong institutional investor appetite, and net-positive fund flows even though flow activity was static from 2024 to 2025. I suspect there is more steepening momentum for the muni yield curve in 2026, unlocking further income and duration opportunities.

This combination should extend the gains booked during the second half of 2025 and set up 2026 for positive performance, which I project to be in the 4% range for investment grade (IG) with modestly higher returns for high yield (HY) munis.

The more predictable muni income streams could offset risk-asset volatility for a growing base of natural fixed income buyers. As I think about munis in 2026, I do so against cautionary economic expectations. As a strategic response to a potential shift in economic conditions, municipal bond investors can take steps to mitigate the effects of portfolio devaluation by staying focused on the defensive attributes offered by municipal securities and seeking strategic deployment of cash where appropriate.

Central to my 2026 outlook, recession is not factored into my base case forecast. If recession does occur, I would expect a mild and short-lived contraction, based largely on proven resiliency that our economy has displayed over the past few years and consistently demonstrated consumer reliability. In any event, a weakened-economy-driven flight-to-quality would likely benefit the muni asset class.

While consumer confidence and engagement have been showing signs of retrenchment, it remains my view that the U.S. consumer will continue to drive economic support, even into the next recessionary cycle. However, consumer sentiment can be tempered by expanding levels of consumer debt, thinner savings, and broadening gaps in socio-economic standing.

Admittedly, growth performance is visibly uneven throughout the regional economies and we are observing diverging employment trends across sectors and business lines against a backdrop of overall flat job advances and higher trending unemployment, conditions supporting a K-shape economy in 2025, and likely to be evident in 2026. Inflation holds a low probability of reigniting, and so the Fed's easing trajectory should take on a preferably slow and steady course rather than an accelerated one that would normally be illustrative of a deep economic contraction.

By mid-December, the Treasury 10-year yield was just under 4.2%, about 35 basis points lower than where it began the year, and reflecting no definitive conviction after the year's final Federal Open Market Committee meeting. I suspect that U.S.Treasury yields will be range-bound until new data entrants tell us otherwise, and quite possibly longer tenor Treasury yields may be propped up due to inflationary concerns and Treasury supply pressure. Such movement of the 10-year may display little correlation with the downward course of short rates, thus further normalizing the steepness of the Treasury yield curve.

Artificial Intelligence (AI) will impact all aspects of the economy, touching virtually every business vertical, and reshaping and differentiating the views currently held by many public finance stakeholders. The dynamics of AI require innovation, a process that will continue to evolve over the years.

Given that the muni market is backdropped by a number of inefficiencies, not the least of which is the large range of over 50,000 issuers, integrating AI into best practices will be challenging given the associated costs, the need for learning tools, the overall selection and management of the data, the importance of preserving market competitiveness, efficiency and risk mitigation, and expectations for enhanced regulatory oversight.

For market stakeholders, the question is "how will we take all of this data and assimilate it into something that is far more analytically powerful?" I do see AI having a significant impact upon many sectors of the muni bond market, particularly surface transportation, higher education, healthcare, and airports. Moving forward, better clarity as to the types of roles issuers will play in developing AI infrastructure, and just how much capital market access would be required, should emerge. AI is a nascent concept in terms of muni market engagement, yet I expect to see a quickly expanding narrative.

The debate over AI data centers will take on greater political, societal, environmental, judicial (potentially), and funding overtones. Anticipated load requirements originating from the growth of AI data centers would likely add a substantive strain on the nation's power grid, elevating the investment needed from utility companies and determining just who would be responsible to cover these expenses.

Similar circumstances may also involve rising demand for water as a byproduct of an expanding AI data center presence. In my view, municipalities and/or ratepayers would likely give meaningful pushback to absorbing associated expenses, thus giving public utility issuers another consideration in their debt-management plans.

A view from Washington

Soon after Donald Trump was sworn in on January 20, 2025, his administration embarked on a multi-point policy campaign that infused a great deal of uncertainty into both the financial markets and the global economic outlook. This was led by an urgent mission to renegotiate what the president terms unfair trade practices and unacceptable trade imbalances by levying tariffs on a broad range of imported products from our trading partners. This trade rebalancing initiative remains embroiled in fits and starts without having clear messaging on GDP and inflation, and will likely present continued challenges in 2026, albeit less disruptive.

Market volatility was a frequent visitor in 2025, as it became the norm with 2020's COVID pandemic, rising inflation and monetary policy uncertainty in 2021, and in 2022 and 2023 thanks to the Fed's aggressive and unprecedented tightening sequence specifically orchestrated to break the grip of the highest inflation levels in 40 years.

Sharp downward swings in asset valuations gripped the global financial markets with unrelenting force upon the April 2, 2025, ("Liberation Day") tariff announcement. While a 90-day pause was implemented on April 9th, resulting in a risk-on recovery that elevated the domestic equity markets to new heights, trade uncertainty lingered throughout the ensuing months. For 2026, the markets need to guard against pricing in too much risk.

The impact of "Liberation Day" upon the muni bond market was not immediate, but it eventually sunk in. Long yields actually declined initially by 20 basis points over the next two days before spiking by 65 basis points through April 11. Throughout the next two months, muni yields were largely range-bound. Muni market anxiety eased up with Trump's July signature on the One Big Beautiful Bill Act, catalyzing positive returns and outperformance, and paving the way to lower year-end yields thanks to the muni tax-exemption being preserved.

While there were no direct threats to eliminate the tax exemption ? which according to the Bipartisan Policy Center costs the federal government about $25 billion annually in lost revenue ? it did appear on a list of "pay-fors" as the OBBBA was being crafted. Although the legislation made permanent certain expiring corporate tax cuts, long-term implications for the national debt remain an ongoing concern.

The next shoe to drop was the record 43-day U.S. government shutdown, which underscored labor market concerns and led to the suspension of key economic releases. The Congressional Budget Office (CBO) estimates the shutdown will lower annualized GDP growth in Q4 of 2025 by 1.0 to 2.0 percentage points. A subsequent recovery can be expected to lift Q1 2026 GDP. Nevertheless, the CBO projects a permanent GDP loss of between $7 billion and $14 billion (in 2025 dollars).

Following the December release of Q3 GDP ? showing that the economy grew at a consumer-driven, stronger-than expected annualized rate of 4.3% ? the effects of the shutdown may dilute subsequent growth, particularly in Q4 2025. The shutdown had minimal impact upon the muni market, but certain sectors were being closely watched, such as affordable housing, GARVEES, higher education, transportation, and GSA-leased assets.

The political debate will likely heat up in 2026, given the November mid-terms, and so I do not expect any new substantive legislative policies having outsized spending priorities to emerge from Washington. Generally speaking, legislative inertia is often viewed favorably by the financial markets. Deficits and higher debt service costs on U.S. government debt matter, and they will matter more in 2026 and beyond.

All 435 seats in the House of Representatives and 35 of the 100 Senate seats are up for re-election. Republicans hold a narrow command in the House (220 to 213, with two vacancies), and they control the Senate with a 53 to 47 majority.

Although Democrats are showing favorable polling, which could result in a power shift within the House, it would be more challenging for the Senate to turn blue, so we may end up with a split Congress and thin margins of control. Should the GOP retain a majority in the House, I would expect climate change initiatives, proposals for tax increases, and new regulatory oversight for businesses to stay out of that chamber's core agenda.

Easier monetary policy comes with high expectations

Beginning with a 50-basis-point rate cut in September 2024, the first policy easing since March 2020, the Fed focused on the second element of its dual mandate given evidence of slowing job creation as inflation moved closer (sort of) to target.

With concerns over tariffs and other policy moves throughout much of 2025, the Fed held rates steady after cutting by 25 basis points in November and December 2024, and only resumed its easing bias in September 2025, with a 25-basis-point reduction. This move was followed by 25-basis-point cuts in October and December, bringing total easing during the current cycle to 175 basis points.

The central bank's policy shift was meant to encourage business investment and consumer spending, stimulate hiring as the pathway to a stabilized labor market, and to extend the growth cycle, thereby avoiding recession. Although economic data delivery was sparse during the shutdown, the Fed still had sufficient guidance as it kept to its schedule of policy sessions, relying upon tools such as the central bank's own Beige Book, a compendium of economic conditions across the 12 Federal Reserve districts. The Beige Book has signaled challenging labor market factors, with reasonable expectations that similar revelations are coming.

The markets have reached the point where each of the eight annual policy meetings command global attention, and 2026 FOMC gatherings have the potential to upstage given that Jerome Powell's term as chair ends in May, and it is not widely expected that he will finish out his term as a member of the Board of Governors through January, 2028. Following a heavy dose of political rhetoric surrounding Powell's performance, Trump is expected to nominate his successor soon, and I suspect that the central bank's credibility as an independent entity will be subject to mounting scrutiny in 2026.

Still, Powell is orchestrating policy against challenging circumstances as the Fed preserves its mission of taking inflation down to target while arriving at a soft-landing, and I expect future "dot plots" to take account of evolving economic conditions. Although further easing is anticipated in 2026, it appears that the bar has been raised for additional rate cuts after the December 2025 FOMC. Looking at the fed funds futures contracts, any substantive conviction for a rate cut is not seen until June 2026, generally in line with central bank messaging, and likely reflecting a more dovish Fed chairman arriving in May.

Now with the central bank concluding its quantitative tightening (a/k/a balance sheet runoff) campaign, 2026 will see a pivot to more pronounced balance sheet liquidity management as a way to ensure sufficient reserves in the banking system. During his December press conference, Powell made every effort to distinguish between an accelerated schedule for initiating purchases of shorter-term Treasury securities as needed to maintain an ample supply of reserves and any form of quantitative easing. I suspect this tactical move will be subject to stakeholder interpretation during 2026.

The Fed will not be on a predetermined course in 2026 as data dependency should guide policy. While I would argue against frontloading too many rate cuts, particularly given still-emerging tariff-related price increases for various goods as well as higher service sector costs, more rate cuts than expected could come about should the labor market picture appreciably deteriorate from its already cooling perch and become more consequential than inflationary pressures. Having said this, the impact from tariffs is expected to be short-lived, and service sector pricing is on a disinflationary course.

Powell's own messaging has been designed to preserve runway for the Fed to hold rates steady should disinflationary progress, which is not expected to come in a straight line, lose momentum.

Unless inflation surprises to the upside, and/or growth materially exceeds its current course, monetary policy should be presently viewed as less restrictive, with the bond market possibly becoming less reactionary to rate expectations. Following one or two rate cuts in 2026, policy could then be viewed as accommodative. Conversely, outsized growth, more problematic inflation, a shift in market expectations away from an easing bias, and uncertainty over central bank governance could push long-dated U.S. Treasury yields higher.

2025 saw a noticeably divided Fed, as policy sessions broke away from a relatively more recent pattern of unanimous decisions following several decades of dissenting votes, with further divergence likely for 2026, even after a new chair assumes office with an anticipated dovish bias. Dissenting votes are becoming less of a surprise, and I would suggest that the absence of a unanimous vote supports better policy transparency.

According to the Fed's December Summary of Economic Projections (SEP), the median funds rate projected for 2026 was held steady from the September SEP, at 3.4%, with downward revisions to 3.1% anticipated in 2027. Considering the "dot plot" shown in December's SEP, 15 participants forecast a 2026 funds rate above 3%, while 4 expect a sub 3% rate, reflecting divergent views among policymakers.

The next SEP will be released after the March 2026 FOMC meeting, giving central bankers an ample slate of new economic reports to consider, and if the Fed is truly data-dependent, we must be prepared for additional adjustments to the "dot-plot".

Interestingly, the Fed's December SEP revealed a projected rise in median change to real 2026 GDP to 2.3% from the September SEP's 1.8%. Median core PCE during the same time frame was revised modestly lower to 2.5% from 2.6%. The recent SEP no longer characterizes unemployment as being low, with the median SEP unemployment rate for 2026 projected at 4.4%.

As I consider the current disinflationary environment, the U.S. unemployment rate inched up in Q4, and the anticipated stability in 2026 could possibly add relief to overall pricing challenges. Should inflationary pressure remain contained, moderate rises in wages can be expected for 2026, thus easing concerns over a wage-price spiral. Although real wages moved in a positive direction during 2025, variances were evident across job type, gender pay, and region.

Job formation continues to slow, although there is noted growth within healthcare, food services and social assistance, while losses are evident across transportation and warehousing, and the federal government. Job openings and hiring rates reached new lows in 2025, with stability anticipated for 2026. Declines in the labor force can partially be attributed to tighter immigration policies, and I do not expect tariff-driven onshoring to produce material job creation in the U.S., given elevated labor costs, automation, and a smaller workforce.

I expect the housing market to show modest improvement during 2026, yet inventory levels and overall demand will be considered against ongoing regional variances, and I would not expect currently anticipated monetary policy easing to appreciably spur the housing market.