The municipal market has priced in a 25 basis point Federal Reserve interest rate increase for shorter maturities, even though some analysts are now suggesting the Fed may wait before making its move.
The Federal Open Market Committee will announce its decision on rates at the end of its meeting Wednesday and Thursday. Policy makers have kept the benchmark rate at zero since 2008 to bolster the economy after the financial crisis.
"We believe the Fed will wait until December 2015 or possibly even early 2016, as there appears little downside risk to holding off," Anthony Valeri, investment strategist at LPL Financial, wrote in a Sept. 10 report.
Valeri said inflation expectations, the yield curve, and stock market volatility have raised the bar for a September rate hike.
"The Fed has a tall task ahead to justify a September rate hike, but it nonetheless remains a possibility," he wrote.
Analysts say the August employment numbers released on Sept. 4 could give the Fed pause as it waits for the release of other economic indicators before acting.
"We would agree that the risks of deferring action are minimal at this juncture," said Jim Grabovac, senior portfolio manager at McDonnell Investment Management in Oak Brook, Ill.
"Headline inflation is flat, personal consumption expenditure core price pressures are falling, broad pressure in wages is not apparent, and the global economy appears to be decelerating," he said in an interview on Friday.
Dollar strength remains "a potent factor" in suppressing both price pressures and economic growth in the current environment, Grabovac added.
In light of these factors, Grabovac said he is cautious regarding the rate hike.
"Fed Fund Futures are currently assigning a fairly low likelihood of a September move, so any action would represent a moderate surprise to the market," Grabovac said.
The current attractive municipal to Treasury yield ratio indicates that the market is positioned for a rate hike, according to Scott Colyer, chief executive officer and chief investment officer at Advisors Asset Management.
Market preparedness aside, Colyer believes the Fed could wait until later in the year to initiate its highly-anticipated rate hike.
"The market may be surprised if we don't get one in September," he said in a Sept. 1 interview. "Muni yields are pretty full on a ratio to Treasuries basis," with municipals yielding more than 100% of their counterparts in 10 years and beyond, he said.
For instance, on Thursday, the 10-year muni to Treasury ratio was at 100.1%, while the 30-year ratio was at 107%, according to Municipal Market Data.
"If the market wasn't ready, then [the ratios] would be down to 80-85%," Colyer said.
The yield curve traditionally cheapens and steepens prior to a tightening cycle, and then flattens post move, according to Sean Carney, director and head of municipal strategy at BlackRock Inc.
"However, with inflation running well below the 2% target it is conceivable that the long-end will hold in and quite possibly rally as uncertainty is replaced with guidance," Carney said on Sept. 1.
"We have put more emphasis on the pace and magnitude of the pending rate hike rather than focus on the actual date," Carney added.
Others said they feel the time is ripe for the long-awaited September rate boost.
"Having a rate increase in September gives the market confidence that the Fed will not get behind inflationary pressures," Dan Heckman, senior fixed income strategist at U.S. Bank Wealth Management, said on Friday.
"The longer the Fed waits to raise rates, the more uncertainty this creates for the market, and increases the possibility that the Fed may have to raise rates in a more aggressive manner to play catch up," Heckman said.
He said the economic backdrop, including the recent unemployment trends and Friday's producer price index figure, is strong enough to justify a rate increase.
The PPI "addresses the concern of any deflationary issues," Heckman said.
"We feel wage pressures are starting to build within the U.S. labor market," he said. "Moving in September removes a great deal of uncertainty for the muni market."
Although the municipal market has already adjusted to accommodate a potential September rate hike, Colyer of AAM believes that potential second, third, or fourth hikes will be more problematic for the market than the first.
"The initial impact of the first rate hike is baked in, so I don't expect much reaction to that," he said.
"When you see the trajectory of how fast and when, that's where you would see more headwinds, and you could see more volume right away," Colyer continued. "As rates go up, that puts downside pressure on pricing. Issuers with anything in the hopper will have an urge to get deals done because the economics would escape them if they wait until after the hike."
Colyer currently recommends minimizing duration risk to 4 ½ to five years and maximizing credit risk to an average of an A rating to earn the best value - regardless of when the first rate hike occurs.
Carney of BlackRock said recent volatility stems partly from the market's attempt to price in the timing of the Fed's plan to normalize interest rates.
"Lift-off is more about removing emergency accommodations and normalizing interest rates over a period of time, as opposed to a traditional rate hiking cycle, which often takes a more pre-determined path," Carney said.
In the meantime, he projects strength for municipals and a manageable impact in the event of any potential weakness due to a rate hike.
"While the muni market will be directionally subject to moves in the broader rates market, we would look for munis to outperform in the front-end of the curve on a relative basis if U.S. Treasuries were to sell-off in any meaningful way," Carney said.
"The impact is more likely to be felt in the one to three year part of the curve as opposed to the five to 10-year part of the curve given the slower and lower magnitude that the Fed has indicated on numerous occasions," Carney added.
Heckman said the long end of the municipal yield curve would benefit from a rate increase and anticipated "slower glide path" for future rate increases.
While analysts are divided and the timing is questionable, the municipal market is exhibiting strength amid the uncertainty.
Overall, supply and demand dynamics in the municipal market remain balanced and ratios to Treasuries are at attractive levels, both of which Carney said bodes well for the tax-exempt market when and if the Fed does raise rates.
If the Fed decides to pull the trigger this week, the municipal market should take it in stride, according to Grabovac.
He compared the impact of a potential September rate hike to that of the "Taper Tantrum," the period in 2013 when yields spiked after then chairman Ben Bernanke first indicated that the Fed would begin reducing its bond buying program.
He said that phenomenon "did most of the damage before it was ever embarked upon."
