This morning, Treasury bonds sold-off amid surging oil prices as inflation fears drove yields higher.  As conflict in the Middle East escalates, disruption in tanker activity and supply concerns will remain in-focus.  Typically global conflict will place downward pressure on rates as investors seek safety; however, in a market already sensitive to inflation and the potential for further rate cuts oil driven inflation concerns have unsettled investors.  

Trading in munis has been muted today, with investors cautiously waiting for additional information.  Over the past month munis have generally lagged the rally in Treasuries, particularly for tenors past 2-years.  The result has been a Treasury curve that has flattened about 18 bps while the muni curve steepened by about 6 bps.  Recent activity is the continuation of a long-term trend in muni/Treasury ratios with ratios at the extreme short-end becoming more rich (less appealing) and ratios on the long-end becoming cheaper (more appealing).  Currently, ratios for maturities shorter than 1-year are yielding 58.5% of their Treasury equivalents while 30-year munis are yielding over 90% of equivalent Treasuries.  

Despite the headlines and anxiety leading up to last week’s supreme court ruling, which determined the reciprocal tariffs are illegal, the bond market’s response was fairly measured.  The Treasury market initially reacted with longer dated yields jumping approximately 6 basis points to 4.75%, before settling back as more information emerged.  The muted response was partly due to the markets anticipating the ruling by pricing-in the outcome in advance and partly due to the potential for replacement tariffs.  However, there remains significant uncertainty about when, or if, the billions in collected tariffs will be refunded.  Should the tariffs be refunded, the bond market currently anticipates the burden will be shifted to Treasury issuance and result in higher yields.

Last week we experienced the second government shutdown in just four months.  Following the approval of a spending package by Congress last Tuesday afternoon, funding for the majority of federal agencies was secured through September.  However, the package only funded Homeland Security through 2/13 (this Friday).  Keep in mind that Homeland Security isn’t just ICE, it also includes: TSA, FEMA, the Coast Guard and the Secret Service.  Should Homeland Security fail to receive funding, there is the potential for economic consequences and travel interruptions.

As a result of the shutdown, the Department of Labor was not able to issue its report on U.S. hiring in January, as scheduled last Friday.  The Bureau of Labor Statistics has rescheduled the release of The Employment Situation for this Wednesday, February 11 and CPI is scheduled to be released on Friday.  Unfortunately, the disruption in jobs data comes amid uncertainty regarding the strength of the labor market amid speculation about the timing of future interest rate cuts by the Fed.  Currently, the fed-funds futures market is anticipating a 25bps cut later this year in June.

Although the Federal Reserve’s rate decision was the primary economic event last week, the President’s announcement of his Fed chair nominee was arguably more impactful.  Markets had a mixed response to the selection of Kevin Warsh as the next Fed chair.  While his qualifications, particularly his experience as Fed governor from 2006 to 2011, were welcome news; there remains significant uncertainty about how he will balance the attentions of the Federal Reserve.  Fed policymakers have recently been divided on whether to prioritize labor market concerns or stubbornly high inflation that remains above target levels.

In addition, the partial shutdown of the government took effect on Saturday, as lawmakers struggle to find common ground on the funding of immigration agencies.  However, since Congress already passed half of this year’s funding bills last year, several federal agencies and programs continue to operate through September.  Nevertheless, the government shutdown still affects the departments of Defense, Homeland Security, Labor, Health and Human Services, Education, Treasury and Housing and Urban Development, in addition to agencies like the Securities and Exchange Commission.  Also, should the shutdown persists through the week, Friday’s Labor Department’s jobs report could potentially be delayed.  

This morning on the trade desk, accounts are distracted by Winter Storm Fern, which has created havoc from Texas to Maine with 24 states declaring emergencies.  In addition to widespread power outages, many roads and highways remain impassable and flight cancellations have reached levels not seen since the early days of the Pandemic.  Despite the inclement weather, Treasuries rose over the five to 30-year tenors resulting in yields dropping to their lowest levels since last week’s volatility.  Following a preliminary announcement by the Commerce Department of stronger than anticipated durable goods orders for November, gains were briefly pared.

Early last week, international events came into focus following instability in the Japanese bond market. Yields surged in the Japanese bond market following a pitch by Japanese Prime Minister Sanae Takaichi to cut taxes on food, which markets interpreted to mean increased government bond issuance.  The result was 40-year Japanese yields jumping to the highest level of any maturity of the nation’s sovereign debt in more than three decades.  In addition, escalating tensions over the control of Greenland with the threat of tariffs on European goods added to the melee.  The municipal bond market responded to the uncertainty with bonds selling-off.  As of the end of the day on Tuesday, MMD ultimately cut yields from 2bps in 2027-28 to 7 bps in 2041-56.

Last week, the Bureau of Labor Statistics reported a drop in the unemployment rate to 4.4% in December, down from 4.5% in November.  However, nonfarm payroll employment levels crept up by 50,000 workers, which was less than the downwardly revised 56,000 in November and short of analyst estimates.  Overall, it was a mixed report that supports the narrative of a low hire, low fire job market and is unlikely to inspire a rate cut at the FOMC meeting later this month.  Although December’s employment data did little to provide the clarity the capital markets are seeking, it was also not sufficiently weak to warrant a rate cut.  Currently, fed funds futures are pricing-in only a 5% change of the Fed cutting rates in January.

The markets responded to this news with Treasuries selling-off, largely around the policy sensitive 2-year tenor with Treasury yields largely unchanged past about 10-years.  Conversely, ‘AAA’ municipal yields fell across the curve, with the largest declines concentrated in the first few years.  The rally in munis was largely supply driven following a modest calendar at year-end and a bit of a slow start to the new year.  However, weekend news of the US central bank being subpoenaed by the Justice Department with threats of criminal indictment have markets concerned about Fed independence.  In addition, this week is a heavy week for economic data with December’s Consumer Price Index scheduled to be released on Tuesday and November’s Producer Price Index scheduled to be released on Wednesday.  As markets digest these events there is heightened level of risk for rate volatility over the next few days.  In addition, as shown below, ACM 10-year Treasury term premium are at about the highest levels seen in over a decade.  This is an indication of some nervousness about future and provides bond investors with a reward for assuming duration.