It’s the exact opposite of what’s considered a normal yield curve, because ordinarily investors require additional interest compensation for the illiquidity of tying up their money longer term, plus a yield premium to compensate for interest rate risk on longer-term paper — what’s known as duration risk.
Astute state and local government treasurers and financial managers must now take into account the dynamic nature of the inverted yield curve scenario and adjust their strategies accordingly. Oversight committees and governing boards should be scheduling study sessions to get up to speed.
For the yield curve to invert, investors must predominantly expect that interest rates will decline in the future, enough to compensate for these longer-maturity risks. Generally this implies an imminent recession, or at least a “soft landing,” as the economy slows down and inflation subsides.
Meanwhile, there is now a quirk in oddly low ultra-short Treasury bill interest rates that reflects the apprehension of some investors to buy U.S. paper maturing midyear in 2023 because of the debt-ceiling follies on Capitol Hill. This has nothing to do with the predominant overall shape of the yield curve. Nonetheless, there is reason for public-sector cash managers to make sure they build in some alternative liquidity in their portfolios this summer, as I explained in January. For those averse to holding Treasury bills while Congress plays chicken with the national debt ceiling, there are ample alternatives for parking cash to be deployed within one to six months, including money market mutual funds, overcollateralized repurchase agreements, and insured or collateralized bank CDs.
Speaking of repurchase agreements, until Congress resolves the debt-ceiling debate, cash managers who buy repos should now include a contract clause that their specified eligible collateral securities cannot have 2023 maturities. That mitigates the risk of a technical default on those short-term investments.
Looking beyond this summer, textbook economics tells us that inverted yield curves cannot persist indefinitely. It’s impossible for banks to make money by paying high rates for deposits while holding loans and longer-term bonds acquired at lower rates. Such underwater portfolios are exactly what ails some corners of the banking industry right now, as the recent bank failures have demonstrated.
Barring Argentine-style hyperinflation, when the currency plummets irretrievably, the rationale for a normal yield curve is like the laws of gravity: Eventually an upward slope must return to the money market, and it’s only a matter of time. The only question is how high the central bank must push short rates in order to squash inflation, and whether that process thrusts the economy into a tailspin.
Right now, the soft-landing and recession scenarios are both plausible, and only time will tell which is right. Either way, traders now sense that the Fed is nearing the peak of its 13-month rate-hiking cycle. Inflation rates now seem to be drifting downward, and it’s likely only a question of time and velocity. Economists and market pundits can debate for another year whether and when we’ll eventually get back to “normal” 2 percent consumer inflation, but directionally, it’s pretty clear that lower inflation and lower rates do eventually lie ahead.
Rethinking Cash Management
For public-sector cash managers and those who oversee outsourced portfolios, the new challenge today is that the strategies they employed in recent years — to invest as far out on the yield curve as possible given their cash-flow models — blew up in their faces in 2022 and gave them market price losses. So they held on to those underwater investments to save face rather than admit to mistakes.
By this summer’s end, the portfolio maturity statistics for 2023 will almost inevitably reveal that at the end of the day many were just chasing yields all along, and their “hold to maturity” excuses were not really any different from the money-losing tactics of so many of the failed and now-underwater bank managers. The public financiers were just lucky that their time horizons were shorter, although the recent 12-month, 26 percent run on the California treasurer’s local agency investment pool certainly exhibited the same phenomenon of disintermediation as the Silicon Valley and First Republic bank collapses — just in slow motion, with California taxpayers silently picking up most of the tab and not the Federal Deposit Insurance Corp.
So where should cash managers place their money now? It’s hard to argue against shorter maturities that pay higher yields, because we still don’t know when inflation will subside. The Fed could go higher for longer. Keeping some liquidity in a state or local treasury portfolio in this period of uncertainty is clearly the path of least resistance and arguably the most prudent for those managing taxpayer funds. But that’s only one side of the coin.
At the same time, there is good reason to expect that by this time next year, a lower overnight interest rate regime will be quite plausible even if there is no recession. Wall Street and the futures traders are probably right that rates will be trending lower in 2024, but it’s hard to envision both inflation and Fed funds rates below 3 percent in just 12 months barring a painful recession. So the next several months should be a good time to look for prudent ways to cherry-pick the best rates for 2024 as they become available. But that requires public investors to do the math and be very selective.
Yield curve break-even analysis in the weeks and months ahead may show that it’s actually smarter to take a lower rate on a longer maturity, to lock up some future yield outside of the Treasury market. In this case, that means seeking rewards for illiquidity. Usually the money market will pay a premium for locking up some cash reserves for 12 to 20 months. If the rest of public cash managers’ portfolios have ample liquidity to pay bills in case a recession hits, then that’s a privileged and advantageous position for them that many of their corporate counterparts cannot muster.
Tactical Tips
For starters, keep in mind that fears of a summertime federal debt ceiling crisis are driving some big-money traders into longer-term Treasury bonds, which has pressured those instruments’ yields lower. That could prove temporary if and when the Washington politicians resolve their fiscal standoff, so the strategies that follow could get better after a deal is done. For those who elect to wait and see, the opportunities identified below may need some time to set up. Conversely, if Beltway brinksmanship plunges us into a recession, the rate window will already be closed. So most strategies here are scenario-dependent.
Instead of buying Treasury bills, notes and bonds, where rates have already plunged, the coming months could be a good time to selectively lock up interest rates in a smattering of less-liquid and typically higher-yielding cash management instruments. That includes bank CDs and possibly even the highest-quality corporate paper (commercial paper and medium-term notes where legally allowed). The most important caveat here is to avoid marrying illiquidity with credit risk, and to be amply compensated. Treasurers must resist the temptation to lock themselves into fishy paper just to glean a few basis points in yield. Remember what market veterans say about picking up nickels ahead of a steamroller when there are dimes on the wayside.
FDIC-insured bank CDs with maturities in 2024 and premium rates could soon make sense for smaller jurisdictions. For larger portfolios that cannot secure the deposit insurance at scale, it means heavy-duty credit analysis. That requires a serious conversation between the portfolio manager — whether internal or external — and the responsible oversight officials who should be reviewing the list of eligible issuers with suspicious eyes.
A possibility where suitable by law, policy and the cash-flow forecast would be AAA-rated federal agency issues maturing in a year or more, where their yield spreads are sequentially higher versus Treasury notes. Federal Home Loan Bank (Freddie Mac) paper is an example. Some dealers may also be able to present in-state or otherwise qualified AA-rated taxable muni notes maturing within 18 months that are worth checking out where investment policies allow. Many of these notes are “callable” — redeemable on demand on specified dates— so the preferable choices are low-coupon paper trading today at a price discount. Just don’t expect to sell them later without a price haircut.
Admittedly, these strategies are already a bit late. The peak in two-year Treasury note yields was likely reached two months ago at 5 percent, which apparently was the ideal time to lock up those rates. So the point now should be to avoid a painfully abrupt loss of interest income in 2024 if the recession scenario plays out. Just remember that there are no public-sector bonuses for outperforming the market, so caveat emptor should prevail. Those who are inclined to lock up future rates should tiptoe, not plunge.
And for those sleepy California agencies that still have money in their state treasurer’s pool paying them only 3 percent, it’s not too late to find better alternatives in light of overnight Fed Funds rates around 5 percent, a 16-year high. You’d have to work really hard to do worse.
Cheap Money in Muni Debt
For debt managers, the prospect of lower interest rates across the yield curve in a year or two is coupled with an interesting recent development in the municipal bond market. Because of supply-demand factors, it turns out that short-term municipal debt trades today at interest rates well below today’s inflation rates, so money is relatively cheap for shorter-term muni borrowers who can undercut inflation this year.
Unlike the Treasury yield curve, the muni curve is not inverted; it’s relatively flat. And on the longer end of the yield curves for muni bonds, the higher rates on tax-exempt paper still favor investors more than issuers. So this would be a sensible time for those who are funding capital projects to deploy shorter-term interim financing rather than long-term permanent bond issues.
There is also a lower-rate “belly” or “swayback” in the AAA-rated muni yield curve recently that favors issuers of five-year to 10-year paper. Serial muni bond issuers will enjoy the benefits of that structure if they adopt equal annual principal payments rather than “level debt service” — the latter more like a mortgage schedule with principal back-loaded. An equal principal payment structure will push more of the interest costs to the time range where rates are now lowest, which can save taxpayers money in the long run. It’s a clear case of today’s muni market encouraging and rewarding fiscal conservatism.
Let’s all hope that the Fed is successful and its efforts to squeeze inflation out of our economy can succeed, especially if that can be achieved without inducing a recession. A soft landing would be wonderful, but let’s not make that the base case for now. And don’t expect the yield curve to maintain its current level and structure for more than a year: Markets are dynamic, and today’s configuration should ultimately drive change in both the economy and the structure of interest rates in 2024. Financial market and securities analysis is almost always more complicated at inflection points like this, so nimble public finance professionals must do their homework first and couple agility with prudence.
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 specific investment advice.
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