The Bull Case for Tax-Free Bonds

The current backdrop for interest rates and bond yields is far different than just six weeks ago.

On Sept. 18, the Federal Reserve slashed the fed funds rate by 50 basis points in response to data pointing to a not-so-soft landing within the labor market. That, and rapidly deteriorating economic data from China, Germany and Canada, prompted the Chinese government to launch an extensive stimulus plan, while the European Union cut rates by a quarter point on Oct. 17 for a third time since June to 3.25% and the Bank of Canada trimmed rates on Oct. 23 by 50 basis points to 3.75%.

Outside the United States, there are serious growth concerns. The U.S. economy has proven more resilient, probably because ours is weighted heavily on services versus manufacturing. The service economy makes up around 79% of U.S. gross domestic product (GDP) and ranks among the top countries where services far exceed what the manufacturing sector contributes to GDP. So, as long as the labor market remains stable and resilient during periods of slower hiring, it implies that a 2-4% rate of growth can be maintained with inflation meandering lower.

Around the globe, other key economies that depend more on exports, such as Mexico, Australia, Brazil and other Asian countries, are seeing some gradual slowing of manufacturing activity, while India is experiencing rapid GDP growth of 8.2%, supported by a buoyant manufacturing sector that grew by 9.9% during the 2023-2024 period. It makes sense that additional global companies are moving more of their manufacturing operations to India, especially in the consumer electronics sector.

One can argue that this set of conditions, coupled with companies spending vast amounts on investment capital in the race to automate via AI innovations, is helping a great deal to keep the U.S. economy on relatively good footing. However, if those developed economies and those of our largest trading partners are experiencing subdued growth, then it stands to reason there will be an eventual drag on the U.S. economy at some point.

With that said, the bond market is now convinced the Fed will dial back its tightening of monetary policy with the stock market taking this message as one of future sales and earnings prosperity that has yet to be priced into stocks. Hence, the rally for the S&P to hit 6,000 by yearend looks to be on course to finish the year with a nearly a 25% gain, even as the fed funds rate sits at 4.75-5.00%, the average 30-year mortgage touches 6.6% and prices for most food, shelter and services stay up. According to the U.S. Bureau of Labor Statistics, the Consumer Price Index (CPI), which measures the average change in prices paid by consumers for goods and services, has risen by approximately 20% from 2020 to 2024.

Source: www.usinflationcalculator.com.

Aside from tens of millions of Americans finding it super challenging to manage the cost of living, one of the biggest drags this inflation surge has had is on the federal deficit that is growing at a rate of 8% year over year. True to form, the federal government has spent $1.83 trillion more than it has collected in fiscal year 2024 that ends Sept. 30. This is an increase of $138 billion compared to the previous fiscal year. And there is little discussion on the Presidential or Congressional campaign trails to slash deficit spending and address the national debt that is fast approaching $36 trillion.

One can strongly argue that in order to maintain the secular bull market, fiscal policy on Capital Hill will have to change, and it will likely only change in a bipartisan manner if both spending is cut, and taxes are raised. Outside of this arrangement, little if any structurally positive spending and tax policy will emerge from the next administration and Congress with the risk of blowing a hole through the debt ceiling. Changes will come at some point because there won’t be any alternatives.

When those changes come, the allure of owning investment-grade, tax-free bonds will likely attract investors like bees on honey. In fiscal year 2023, individuals accounted for 49% of the total federal revenue. The government already derives nearly half of its revenue from taxing people’s income. And the top 1% of earners pay nearly 46% of all income taxes.

If taxes are going up further in the future to address an ongoing and rising revenue shortfall, then those taxpayers in the higher brackets might want to consider loading up on investment-grade tax free bonds at today’s prices before the Fed cuts rates further and the IRS starts looking to take more of your pre-tax income. There are several ways to purchase tax-free bonds — individually, through closed-end funds, mutual funds or exchange-traded funds (ETFs). As the Fed continues to reduce rates and Congress is forced to raise taxes to stave off a federal debt meltdown, tax-free municipal bonds will flourish in price and demand. Leave no doubt that this fiscal white-knuckle train ride is coming down the track.

One may as well be ready when it gets hot and heavy.