Muni Market Q&A: Strategas’ 2022 Outlook

2021 ended with a political cliffhanger – the fate of the Biden administration’s Build Back Better bill. You previously discussed the potential impact this legislation could have on the municipal market – what are the odds of it passing in 2022?

That’s hard to say. We mentioned before that for this bill to pass, it will need all the Democrats in the Senate to sign off and virtually all the Democrats in the House. What’s come to light, though, are fundamental differences between different factions of the Democratic party, and it’s not at all clear they’ll be able to resolve their differences with a compromise bill – especially given the added spotlight of an election year. That said, the longer this lays out there, the greater the chance it could get whittled down into something that could pass, though who knows what that something might be.

What’s interesting is that high-income taxpayers, in anticipation of higher tax rates resulting from this legislation, already pulled forward a great deal of their income into 2021. By all accounts that should lead to a surge of both federal as well as state taxes for 2022. When you add about $1 trillion in previous stimulus from the federal government to states and local governments on top of that, that puts municipal governments – particularly states, but to a lesser extent local governments – in a very sound financial position.

What about the individual policies within the Build Back Better bill?

I would say they are all on pause, but not necessarily dead. The failure to pass this legislation makes it difficult to expand the state and local tax (SALT) deduction retroactive for 2021. That means many taxpayers in states like New York, New Jersey, Connecticut, California and Massachusetts are still going to pay higher federal income taxes due to their large deductions getting capped. It also puts an end to the popular child tax credit, at least temporarily.

In addition, there were several provisions that didn't make it into the most recent Build Back Better bill but would have been beneficial to munis. Advanced refundings, an expansion of bank qualified debt and a direct-pay bond program were all included in previous drafts. There's broad, bipartisan support for these policies, so as Democrats try to retool the legislation into something that could pass, it’s possible we could see them in a new package in 2022.

What do you think is keeping the bill from passing?

It’s tough to read the tea leaves, especially when talking about the motivations of individual legislators like Senator Manchin of West Viriginia. But one point that’s worth mentioning is that while Democrats have been touting the bill as an inflation mitigator, Republicans have called the bill an inflation accelerator. There are legitimate reasons to be worried about inflation, and inflation will hurt the people of West Virginia more than it will the people of New York City.

There’s been a lot of chatter the past few weeks about the Federal Reserve tapering, if not ending, its bond buying policy in 2022 and raising interest rates. What decisions do you anticipate coming from the Fed, and can you connect the dots as to how those actions might affect inflation?

That's a good question. In terms of our expectations around monetary policy, we’re looking for four rate hikes in 2022. We also expect the Fed’s balance sheet tapering to end by mid-March, which means no new net purchases, Treasurys or mortgage-backed securities.

As a result, we expect the front end of the yield curve – say, two-year Treasurys – to move higher in an almost linear way, from an upper target of 25 basis points today to an upper target of 125 basis points by the end of the year. Now, if the Fed were to continue to buy Treasurys – that is, raising rates but not fully tapering – then you would almost certainly see an inverted Treasury curve, because 10-year yields cannot gain much traction here. Raising the fed funds rate isn’t as big a driver of 10-year yields as supply and demand, and so long as the Fed is still buying up the net float of Treasurys, there is no supply. We believe this is why the Fed has to consider shrinking its balance sheet for 2023. We could see subtle comments to that effect with January’s meeting minutes, and I wouldn’t be surprised if we saw a vote on reducing the Fed’s balance sheet by the end of the year.

But even if that doesn't happen, as supply begins to tick up from April to December, you should start to get 10-year yields moving a little bit higher, which would allow the curve to slowly start steepening, or at least moving parallel with the front end of the curve. It's the same on the mortgage side: Assuming the Fed stays on this path of four rate hikes in 2022 and is out of the bond-buying business by April, you should at some point get 10-year yields above 2% and avoid an inverted yield curve.

Our base case forecast would be a flatter curve from current levels, but an overall curve between 50 and 75 basis points higher than we see here. Overall, we're bearish on bonds, but we continue to respect the fact that the market is positioned toward a steeper curve. So even though the yield curve has been flattening since mid-October, we expect it to flatten some more before it starts to steepen, and that means 10-year yields still have a cap on how much they can rise in the near term.

You also asked how these decisions could impact inflation. Raising the fed funds rate puts more strain on Main Street, and – so long as the increases are slow and telegraphed – tends to benefit Wall Street, particularly institutions that use a combination of short- and long-term borrowing to supply liquidity to the market. By using the fed funds rate to tighten monetary policy, the Fed shifts capital away from those who need it, like small businesses that have high inventory management or that finance their payrolls with money market borrowings. Flattening the curve funnels capital to the long-term credits that are super-solvent but hoard cash. And in an economy that is trying to transition to new growth engines, that puts a lot of strain on Main Street.

In contrast, let's say the Fed decided every $500 billion of buying is equivalent to a rate hike of 25 basis points, and instead of raising rates, they decided to shrink the balance sheet by $1.5 trillion. In that scenario, almost all the burden would fall on the financial markets, and the curve would steepen 200 basis points. You’d have to deal with severe financial market volatility – for example, we would see 30-year mortgage rates quickly rise to 5% or so – but Main Street would likely perform better than Wall Street. There aren’t a lot of small businesses that are financing themselves with 10- to 30-year debt.

I’d argue the best tools for the Fed to use are a combination of rate increases and balance sheet reduction to diversify the burden between Main Street and Wall Street. Right now they're only willing to use the fed funds rate, but the Bank of England has already decided to use the balance sheet and the short-term borrowing costs to tighten policy, and I think the Fed will come around to that as well – even if it’s only passively, like just letting existing maturities run off.

You mentioned that base case is a flatter yield curve compared to current levels. Would a steeper curve indicate a healthier economy?

We would go one step further and say a steeper yield curve can be a causative factor because it allows for credit to flow more freely to certain areas, such as auto loans and small businesses, whereas a flattening curve really squeezes those types of borrowings. Households with low discretionary income, families taking out student loans, small businesses with inventory and payroll management costs – all of those get hurt when you raise rates on the short end of the curve and the curve flattens.

A steeper curve should have none of those consequences and could actually increase the flow of credit more broadly because of the rising net interest margins. That's a positive and one of the things that the Fed should be looking at.

Let's talk about the midterms. How could the midterm elections impact the market?

Midterm elections always create volatility for equity markets – intra-year drawdowns for the S&P could easily be something like 15% in 2022. For equity investors, this typically leads to potential buying opportunities, because as you head out the other side of the midterms, you get policy certainty as well as two years where the administration wants to prime the pump ahead of the new reelection cycle.

Traditionally in the 12 months following the peak drawdown in a midterm year, you get a roughly 32% positive return. What this means for the muni market is that just on the equity volatility alone, state and federal capital gains tax receipts should be quite high for the next calendar year. They might drop substantially in 2023, but then they should begin to rise again in 2024. That's the cycle that we seem to be on in terms of tax receipts.

In the political landscape, there’s a very good chance the Republicans will take back one if not both houses of Congress, and quite possibly make further gains at the state levels as well. That means the Democrats would have to try to get their fiscal agenda for 2022 passed before candidates go out to campaign in late July. I’d argue that anything they want to get passed has to do so by April, because after that it gets really hard. If you get to April and Build Back Better hasn’t been passed, Senator Manchin's bargaining position just grows stronger. So, if they're going to get a deal done, it's going to have to happen in the first quarter or not at all.

In terms of fiscal policy, I think you're going to get a stalemate across the board. The Republican plan seems to be to just grind out the year and try to take back the House and Senate in November. I see no incentive for Republicans to accommodate the administration in 2022. I think you're going to see more political volatility and greater equity market volatility, which also means that municipal borrowers might only have a small window to get new issuance off at really attractive interest rates – probably only the first quarter, before the Fed ends its bond buying and finishes tapering. Because from that point on, the political environment is going to probably get more volatile, and borrowing costs are going to be rising across the curve.

What do you expect in terms of income tax changes for 2022?

A lot will depend on the passage of the Build Back Better bill. The latest iteration of the bill imposed a new income surtax on single taxpayers making $5 million ($10 million for married taxpayers) and an 8% surtax on single taxpayers making $12.5 million ($25 million for married taxpayers). This surtax would be a new tax on all income, including capital gains and dividends. So if Build Back Better were enacted, the top federal income tax rate will be 45% with capital gains, and dividends would increase to 32%. Even though this would only affect roughly 22,000 taxpayers, the new tax would impact about one-third of all capital gains realizations. Higher taxes on capital gains and dividends would drive demand for more tax-efficient strategies like municipal bonds. Should they be enacted, we anticipate these tax changes would be retroactive to January 1, 2022.

On the corporate side, Build Back Better looked to impose a 3.8% net investment income tax pass-through. It also sought to institute a corporate minimum tax rate. That likely wouldn’t go into effect until 2023, but it could have an impact on municipals – tax-exempt income in the normal corporate tax system would not be exempt for the purposes of this minimum corporate tax. As such, corporate municipal purchases held at companies with tax rates below 15% would have less incentive to buy munis or other tax-efficient vehicles.

Big picture, should Build Back Better pass in 2022, we're looking at tax increases sometime in the first quarter, retroactive to the start of the year. That should by itself stimulate some stronger demand. What’s unclear is if those increases are already priced in – it’s possible whatever the bill is going to give us in terms of tax policy is already priced in, and the positioning toward those assets has already largely taken place.

There could also be some follow-on effects as the year progresses. Let's say Treasury and ten-year yields rise 100 basis points and munis widen out 10 basis points on top of that. You’d almost certainly start to see more demand due to the more attractive municipal assets on top of retroactive tax increases, bringing really onerous rates to your marginal tax buyer in those brackets.

You mentioned many high-income taxpayers had pulled income into 2021 to avoid a potential tax hike. Could that create a tax shortfall for municipalities for 2023?

It should, for a couple reasons. Beyond the taxes being pulled forward into 2021, there's a good chance that equity markets are down in 2022 – we're in a midterm election year and heading into Federal Reserve tightening, which includes fed funds rate hikes, a potential shrinking of Fed purchases and possibly a reduction of the Fed's portfolio in 2023. All of those are factors that are going to weigh heavily on risk assets and thus short-term capital gains. So it’s very possible we’ll see softer equity markets in 2022 and weak capital gains taxes for 2023 filings.

Along these same lines: It’s worth noting that the consensus expectation among our peers for 2022 is a modest uptick in issuance, or something roughly flat to slightly up versus this past year. I would lean toward the other side – a modest decrease in issuance for the reasons discussed previously, like the pulling forward of tax revenues into 2021 and increase in state and federal government cash reserves. As a result, there's very little need to engage in the type of capital spending or borrowing that would necessitate a large uptick in debt issuance. So I think debt issuance is going to be flat to slightly negative this year, closer to $400 billion of net issuance this year versus the $500 billion or so that seems to be the consensus.