Although the U.S. government shutdown last week, Treasury and municipal markets were largely undaunted with yields experiencing only minimal change.  However, the shutdown has resulted in the Bureau of Labor Statistics postponing its Employment Situation report, which is ordinarily delivered on the first Friday of the month, to report on employment levels and unemployment.  Despite the lack of data, Treasury yields only moved down by about 4 bps on the short-end and up by about 5 basis points on the long-end with the 5-year tenor essentially unchanged.  Muni yields moved in almost the opposite direction, with short yields climbing 2 basis points and long yields falling about 3.5 basis points and, like Treasuries, 5-year yields were essentially unchanged.  Furthermore, the Fed funds futures market is currently indicating an almost certain 94.6% chance of a 25bps rate cut at the Fed’s October 29 meeting.

With government funding set to expire Tuesday, the shadow of a potential government shutdown continues to loom over the bond market bringing yields down across the Treasury curve.  In addition, the shutdown threatens to delay the release of key economic data, including Friday’s nonfarm payroll employment data and unemployment rate from the Bureau of Labor Statistics.  This data is critical to current rate forecasts as weakening employment data was an influential factor in the Fed’s decision to cut rates earlier this month.  The Fed has recently commented that labor demand, and the recent pace of job creation, appear to be running below the “breakeven” rate needed to maintain current unemployment levels.  The Fed funds futures market is currently indicating an 88.7% chance of a 25bps rate cut at its October 29 meeting.

Attentions are focused on the Fed this week with their rate decision scheduled to be announced on Wednesday.  Traders are positioning ahead of Wednesday’s meeting with Fed funds futures continuing to demonstrate conviction of a 25 bps cut.  However, inflation has been creeping higher in recent months and is keeping the Fed cautious.  Last week, the Consumer Price Index for All Urban Consumers increased 0.4% on a seasonally adjusted basis for August after rising 0.2% in July.  The all-items index rose 2.9 percent for the 12-month period ending August, which is significantly above the Fed’s 2% inflation target.  However, many traders are arguing that weaker jobs data outweighs concerns of higher prices.  Last week the Bureau of Labor Statistics reported the U.S. labor market added 911,000 fewer jobs than previously reported, which many in the bond market are interpreting as additional justification for the Fed to cut rates later this week.

Over the past week, both municipal bonds and Treasuries have experienced a meaningful rally which shifted rates lower as sentiment intensifies in anticipation of a Fed rate cut.  Momentum picked-up as the week progressed, with 10-year Treasury yields charging through key support levels on Thursday and Friday.  Ultimately, the largest moves happened on Friday following the release of nonfarm payrolls by the Bureau of Labor Statistics which contributed to bumps in the municipal yield curve ranging from 2 bps in 2026 to 12 bps in 2055.  Prior to the data release, economists surveyed by Dow Jones were anticipating payrolls would rise by 75,000 jobs in August versus the actual survey report of only 22,000 jobs.  In addition to a disappointment versus the survey, this is a significant slowdown from July’s 79,000 job increase.  While the labor market is showing meaningful signs of cooling, unemployment remains at a historically healthy 4.3% and total non-farm payroll continues to set new monthly records.  This morning, the Fed funds futures market is pricing-in a 112% chance of a 25 bps cut at next week’s meeting.

Jerome Powell delivered his highly anticipated keynote address at the Jackson Hole Economic Policy Symposium last Friday.  Prior to the meeting, the bond market’s forecast of a 25 basis point cut at the Fed’s September 16-17 meeting had been diminishing, with Fed Funds Futures indicating the likelihood in the mid-70’s.  Although Powell’s comments were largely cautious, the markets have interpreted his comments as a dovish shift with the probability of a rate cut now pricing in the low 80’s.  Important takeaways from the speech include the conflicting position the Fed faces, amid mounting political pressures, with inflation pegged stubbornly above its 2% target and a languishing labor market.  Perhaps more importantly, and generally ignored by the media, Powell outlined a new framework to guide future Fed decisions.  The Fed’s revised framework is designed to evolve with changes in the structure of the economy and how the Fed interprets those changes.  To accomplish this objective, the language in the existing framework was revised to shift focus away from the effective lower bound and remove some of the communications challenges the Fed has faced in the past with regard to the labor market.

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.

Last week, the municipal market was flooded by issuance as state and local governments unloaded $20 billion in new deals, marking the largest issuance volume in almost eight years.  The municipal market is anticipating another big week with issuers currently scheduled to bring $17 billion in new deals to market ahead of the upcoming FOMC meeting and the Juneteenth holiday.  However, despite the challenging volume of deals being processed by the market, municipal yields have held steady, even outperforming Treasuries, with a rally of two to three basis points in tenors under ten years and a minor sell-off of one to one and a half basis points out long.  As a result, the MMD municipal yield curve has modestly steepened by about 11 basis points over the past week.  In contrast, Treasuries have flattened from two to 30-years with tenors under ten years selling-off as much as ten basis points as the Treasury market responded to a stronger than expected jobs report and continued policy uncertainties.

Long-term US Treasury yields have recently popped-up to their highest level in over a year, driven by the passage of the budget by the US House of Representatives and widespread concerns of escalating deficits.  The biggest deficit driver is the proposed extension of the Tax Cuts and Jobs Act of 2017, which is estimated to add $3.5 to $4.0 trillion to the current deficit, likely requiring the issuance of additional Treasury securities.  However, demand for Treasuries is waning as countries like China and Japan have been decreasing their holdings due to trade tensions and a stronger US dollar.  Yields on 2, 5 and 10-year notes, by comparison, have fallen resulting in a widening gap between the 10-year and the 30-year bond.  Although this gap is widening, it is still within long-term historical averages.