The problem today is that markets have already begun to anticipate a lower-rate environment next year, and thus longer maturities currently carry lower yields. The “give up” trade is hard to explain to those who cannot see beyond their noses.
There is more than just the egos of state and local treasurers at stake. Budget officials need accurate projections of interest income from operating funds, and some may even prod their treasurers to lock in rates now to prevent a sharp drop-off in interest income next year. Already, it looks like general fund interest income revenues in 2025 could be down 10 to 15 percent, and it may be even worse where cash reserves and federal grants are being spent this year.
Meanwhile, debt managers need to decide when is the best time to sell municipal notes and bonds for both cash flow and capital improvements. With trillions of public-sector budget dollars invested in the money markets and interest income again representing a significant revenue line item, these are not trivial decisions.
At the beginning of this year, market mavens expected that the Federal Reserve would be cutting its overnight interest rate as many as six times throughout 2024, with that rate falling to 4 percent or possibly even lower by Christmas. They jumped the gun: Inflation has proved stubbornly stickier than many hoped, so the Fed has repeatedly declined to cut rates too soon for fear of a false start on its monetary normalization efforts. Thus the overnight rate has remained unchanged for almost 12 months. Meanwhile, long-term government bond yields have drifted a bit lower since April, accentuating what’s known as an inverted yield curve, where short rates exceed those of longer maturities.
Historically, the yield curve normally has an upward slope throughout most of each business cycle, to compensate investors for the expectation that interest rates move higher as the economy grows and credit demand expands. An inverted yield curve often arises later in a business cycle, when the Fed is forced to tighten monetary conditions as the demand for credit surges to fund expanding production capacity.
The other scenario that often forces an inverted curve is when inflation has spiked for some other, noncyclical reason and the Fed has to hit the brakes to restore monetary and price stability — just as it’s done for the past two years following both political parties’ COVID-19 check-writing splurge that pumped trillions of dollars into the economy to avert a gruesome pandemic-induced recession.
Provided that inflation rates continue to drift downward — which is still an assumption, but now the base-case forecast in financial markets — the Fed should be able to gradually relax its tight monetary policy, and may in fact be compelled to cut short rates in 2025 to avoid a slump. As a result, the futures market for overnight Fed funds interest rates now anticipates an overnight rate of just 4 percent by this time next year, down a full point from the current rate. At that point, the yield curve would be either essentially flat or even slightly upsloping again.
What the Futures Hold
In essence, the Fed’s postponement of rate cuts has shifted the financial futures market’s outlook back by eight months on traders’ calendars. The cash market for Treasury bills and notes has followed that lead, but not in mathematical lockstep. If the futures seers are right, then it still pays to lock up slightly longer-term yields on 2025 maturities while one can.
For muni bond issuers, the first takeaway from this mental exercise is that longer-term borrowing costs are not likely to decline very much next year, barring a recession that would drive all governmental bond yields materially lower. Decision factors for public finance teams will thus center on (1) the inflation rates they expect for construction projects vs. their cost of capital, (2) whether they can expect to earn a modest profit from investing their unspent bond proceeds during the construction period, and (3) voter approvals of new bond issues. For at least a year, Congress is unlikely to do anything that would create scarcity and thus lower muni bond yields, unless it puts the kibosh on private activity bonds in the next tax bill.
For those who invest operating cash, the dilemma today is that there seems to be little professional advantage to sticking out one’s neck into longer maturities at lower rates if there are no benchmark measures. That’s the typical outlook for internal staffers. In the case of outsourced money managers, the primary force that could drive them into the longer maturities structure is having a performance index with a longer-term focus in the range of one to three years, which several of them employ.
So this could be a point in the market cycle where outside managers would have a structural bias to extend maturities somewhat, contrary to the strategies used by internal cash managers. An elected treasurer who makes a wrong-way bet on lower, longer maturities will suffer reputation loss that outsourced managers working with an indexed policy benchmark can rationalize away as long as they match or slightly outperform that benchmark.
But those who wait until the Fed actually makes its next rate cut could miss the ensuing land rush for paper maturing next year. If short rates fall as rapidly as the futures markets now project, there could be a revenue shortfall in their 2025 budgets that will not be offset by declining expenditures. Cautious budget forecasts should document what the Fed funds futures market now projects, unless budgeteers are informed by the treasury managers that a better rate structure has already been locked in through previous maturity extensions. Either way, such collaboration would be strongly advised, but frankly it’s somewhat rare in jurisdictions with separate budgeting and treasury functions.
The technical tool here is the public-sector version of “break-even analysis,” which requires a simple calculation of what would be the reinvestment rate a treasurer must receive later if they invest twice — once now for a shorter period, and then again later — rather than going for just one longer maturity right now. An “implied forward rate” calculation enables the investor to decide whether the market has already priced in future rate reductions to the point at which there is no advantage in buying longer paper now. Presently, the math says that the cash money market has not reached that crossroads, if today’s futures traders have it right. Maturities between 12 and 20 months now seem to have the best value using that tool.
Politics and the Economy
Some treasurers have asked whether the outcome of the November federal elections will have any bearing on all this. For purposes of the 2025 state and municipal budgeting world, the answer is maybe, but really not that much before 2026. Typically a divided federal government would relinquish the levers to the Federal Reserve. But if either party gains enough control of Capitol Hill to trigger a new round of inflation in 2026 and beyond through various concoctions of partisan spending, tariffs or tax cuts, interest rates could shift upward in an ensuing bond market selloff.
Politics aside, if the national economy unexpectedly heads into a recession on its own because mainstream consumers are overstretched, neither party is likely to have much additional impact on money market rates next year. That will remain the domain of the Federal Reserve. If the economy falters, the Fed would have little choice but to drop its overnight rates below the 4 percent levels already anticipated for next summer, and arguably even lower. Neither party wants that outcome. Pension funds will be impacted next year by November’s outcome far more than state and local operating budgets, as stock and bond markets react to election results and any sort of 2025 tax law theatrics.
The only good reason to keep maturities short nowadays is the possibility that the U.S. economy is sufficiently strong — and inflation holding firmly above 2 percent — that the Fed cuts overnight rates only once or twice, leaving the yield curve still slightly inverted and making it possible to then reinvest later at rates in the high-to-mid fours. Let’s call that the “two [cuts] and done” scenario. It’s hardly the mainstream economic forecast these days, but nobody can rule out that possibility without more evidence of economic deceleration.
This makes today’s money market crossroads an important time for clear communication between the budget and cash management teams. Given the growing outlook for materially lower rates next year, now would be a good time to document the money market decision matrix that confronts those who must make multimillion-dollar revenue decisions. Budget-makers increasingly appear to face a Hobson’s choice between locking in less yield today or being second-guessed later. But that’s the real world of public finance: Decision-makers who sit on the dock until November will likely find that their ship has already sailed without them as cash and futures markets for the ensuing months eventually converge.
Editor’s note: Since the original publication of this column, financial markets have moved substantially in the direction suggested by the author and forecast by financial futures, thus removing the near-term advantage of extending maturities.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.
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