Inflation comes into a closer focus today in the Treasury market with Fed Funds Futures now reflecting an 84% chance of the Fed cutting rates next month.  This is down significantly from last week when the probability was over 100%.  Last week, the credit markets continued to focus on the August 1st Bureau of Labor Statistics nonfarm payrolls report, which included a cumulative downward adjustment of 258,000 jobs and convinced capital markets that a September rate cut was certain.  However, the release of last week’s Producer Price Index, which jumped 0.9% on the month, compared with the Dow Jones estimate for a 0.2% gain, has markets casting doubt.  Although the jobs data was striking, last week’s PPI is the biggest monthly increase we have seen since June 2022 and has the markets re-calibrating expectations.

The municipal yield curve steepened over the past week with a rally in the muni market driving yields down across the curve amid aggressive bidding on the short-end in anticipation of a September Fed rate cut.  Inquiries on the trade desk continue to be concentrated within 10-years and maturities under 5-years are pricing at notably tight levels.  Treasuries, in contrast, flattened over the past week with the market selling-off from 6-months to 30-years with yields rising with greater consequence on the short-end than the long-end.  The August 1st Bureau of Labor Statistics nonfarm payrolls report continues to weigh on the markets with traders focusing on softer payrolls data as justification for the Fed to cut rates at its next meeting.  In addition, the nomination of Council of Economic Advisers Chairman Stephen Miran to serve out the final few months of Adriana Kugler’s seat following her surprise resignation last week has been viewed by the markets as a potentially dovish development.

With the August 1 tariff deadline, a full economic calendar and an FOMC meeting, last week was bound to be a dynamic week.  However, it was Friday’s nonfarm payroll report that proved most impactful.  Total nonfarm payrolls disappointed with little change reported in July with an additional 73,000 jobs, well below Dow Jones’ expectation of 100,000.  Furthermore, the unemployment rate ticked up to 4.2% alongside another decrease in the labor force participation rate.  However, the revisions to May and June were more impactful, with totals revised sharply lower, by a combined 258,000 jobs from previously announced levels.  Markets subsequently repriced the policy outlook for the Fed’s next rate cut with the futures market pricing in the probability of a September rate hike over 90%.  The news was promptly absorbed by the municipal yield curve without prejudice of maturity, with a 7 bps bump per year from 2026 to 2055, resulting in a parallel drop lower in yields.  The Treasury market also responded with yields dropping, largely in the policy sensitive 2-year note, which fell as much as 28 bps.

Throughout the month of July, both the Treasury and municipal yield curves experienced meaningful steepening.  Munis steepened more than Treasuries, largely due to yields falling on the short-end of the curve rather than yields climbing on the long-end.  For the Treasury curve, the steepening was less pronounced as 30-year yields climbed only 2.5 bps and yields around the 1-year mark dropped a significant 16bps.  Currently, the municipal curve is at its steepest around the 10-year tenor with 51 bps of slope from 8 to 11-years.  In addition, after this past week, the curve has steepened notably around the 5-year tenor with 33 basis points of slope from 4 to 7-years.  Overall, the steepness of both curves provides significant incentive for duration extension.

US seasonally adjusted initial jobless claims dropped to 217,000 last week, which marks a 3-month low, supporting speculation the Federal Reserve will keep rates unchanged at this week’s meeting.  Currently, the futures market is pricing-in only a 3% chance of a rate cut at this week’s meeting with the first cut of the year not anticipated until October.  However, the job market may not be as robust as it initially appears.  As noted during our Trader’s Strategic Ideas session earlier this month, continued jobless claims have been steadily increasing over the past 3-years, indicating jobless workers are taking longer to re-enter the labor force.  Last week, continued claims increased to 2.039 million, an increase of 113,926 from the prior week and an extension of this longer-term trend.  Following the Fed’s meeting later this week, we hope to have more clarity on the Fed’s assessment of recent employment and inflation data.

Treasuries outperformed munis during this past week, as both markets moved in opposite directions on the long-end.  Although uncertainty remains high, comments from Fed governor Waller supporting a July rate cut have put downward pressure on Treasury rates while the muni market struggles with: weakening fund demand, heavy supply and growing secondary offerings, particularly for maturities beyond the 10-year tenor.  Looking at inflation expectations via inflation swaps, the market’s concerns become increasingly evident with two-year inflation swaps now over 3%, which is a level we haven’t seen since early 2023.  In addition, with potentially higher tariffs being implemented on August 1, inflation anxiety is likely to be a significant factor this week.

Over the past week, a combination of tariff announcements, fiscal deficit anxiety and inflation concerns have driven long-term Treasury and municipal bond yields higher.  Treasury yields past 10-years have generally risen by 3 to 4 basis points while shorter Treasury yields are generally 1 to 2 basis points lower, resulting in a steeper Treasury curve.  The municipal yield curve exhibited a similar steepening with yields under 10-years generally 2 to 4 basis points lower and yields past 10-years generally 3 to 4 basis points higher.  Looking at the 2s10s spread, which is the difference between the 10-year yield and the 2-year yield as an indicator of the steepness of the yield curve, the municipal curve has recently reached the steepest slope in over 2-years.  This is an invitation for bond investors to extend duration.

Last week, the President signed into law his “Big Beautiful Bill,” which reportedly contains roughly $4.5 trillion in tax cuts, and protects the tax exemption for municipal bonds and private activity bonds.  The Bill also creates a new category of private activity bonds for “spaceports” and includes a few additional bond-related provisions.  The preservation of the tax-exemption is of critical importance to the municipal bond market.

Treasury and municipal market yields rallied over this past week as the market fixated on the potential for the Fed to cut rates earlier than previously forecast.  Sentiment was driven by dovish Fedspeak from Fed governors Bowman and Waller, first quarter GDP revisions to -0.5% and a benign May PCE report, all of which bolstered rate cut expectations.  The futures market is now anticipating the Fed could cut rates as soon as September.  However, Fed Chair Powell’s comments made last week to the House Financial Services Committee were clear, that the Fed is well positioned to wait citing elevated inflation and intensifying price pressures.  Powell also commented that signs of weakness in the labor market would change the Fed’s stance.  As a result, we may see some volatility in the capital markets following this week’s employment data releases on Tuesday and Thursday.

Although last week was a holiday week, there was a steady stream of potentially impactful headlines ranging from escalating tensions in the Middle East to an FOMC meeting.  Although Fed officials left interest rates unchanged at last week’s meeting, the conflict in the middle east has disrupted air traffic, rattled global markets, and raised concerns of oil prices and inflation.  However, Treasury bond yields generally slid last week amid elevated recession concerns following a disappointing release of data by the Census Bureau indicating retail sales dropped by 0.9% in May, significantly below the 0.6% contraction previously estimated by economists surveyed by Dow Jones.

From the perspective of the trade desk, last week was another challenging week with attentions focused on new deals rather than the secondary market.  Both municipal and Treasury markets responded to last week’s reports of slower growth and lower inflation with yields dropping approximately three to six basis points across both curves.  However, this week escalating overseas tensions in Israel and Iran are placing upward pressure on yields.  Not surprisingly, both Brent and West Texas Intermediate crude oil prices have risen above $70 per barrel sparking concerns of inflation among traders and placing additional upward pressure on long-term yields.  These concerns are in addition to the existing inflationary concerns related to the trade wars, spiraling U.S. debt concerns and traders demanding a higher premium for the risk of lending to governments following Moody’s downgrade of the United States credit rating to ‘Aa1.’  Overall, the yield gap between 10 and 30-year Treasuries has reached the widest levels we have seen since 2021.