Municipal yields and inflation: Investors take a long view

In light of the recent sharp increases in the Consumer Price Index (CPI), we consider the historical relationship between inflation and the general level of interest rates on municipal bonds. Our analysis suggests that investors typically take a long view of inflation, requiring consistently strong increases in consumer prices over an extended period before they make major adjustments to how they value municipal bonds and other fixed income securities.

An inconsistent relationship shows general patterns

The oldest series of municipal yields is the Bond Buyer 20 Index (BB20), which tracks the theoretical yields at which high grade general obligation bonds maturing in 20 years would be expected to trade if newly issued.

This series provides monthly average yields going back to January 1953 (which, coincidentally, was one month after the birth of the author of this report). At that time, the BB20 yield was 2.44%. With one exception, yields remained below 3% until November 1956, when they climbed to 3.16%. After June 1958, they never again fell below 3% until June 2016, when they dropped to 2.99%.

As of 30 Dec 2021, the BB20 yield was 2.06%. In other words, the index has returned to roughly where it started nearly 70 years ago. But in the intervening time it has been as high as 13.28% (January 1982) and as low as 2.04% (August 2021).

The relationship between the BB20 and year-over-year changes in inflation has been inconsistent, but with some general patterns:

1. Inflation is only stable at low levels.
2. Inflation is more volatile than municipal yields.
3. Municipal yield changes lag inflation.
4. The market can tolerate a negative spread for longer than one might expect, but yields remain elevated even as inflation recedes.
5. Municipal yields are more closely correlated with inflation over longer periods.

Figure 1 illustrates the relationship between the BB20 and 12-month changes in consumer prices since 1953. The average yield of the BB20 has been 5.22%, while the average 12-month inflation rate has been 3.46%, for an average spread of 1.77%. This is sometimes referred to as the real yield, although it is a projected, rather than a realized, rate of return. This average spread masks a wide dispersion, as the spread has been low as -6.82% (May 1980) and as high as 7.16% (August 1983).

 

Inflation is only stable at low levels

Between January 1953 and June 1968, the average 12-month inflation rate was 1.62%, ranging from -0.74% to 4.20%. During that period, the average standard deviation was 1.15%. Likewise, between October 2008 and December 2020, the average inflation rate was 1.55% with a standard deviation of 1.08%.

On the other hand, inflation averaged 6.98% between June 1968 and March 1980 and 5.40% between March 1980 and October 1990. The standard deviations in those periods were 2.80% and 3.23%, respectively.

As a general rule, inflation persisting above 4% appears to make it harder for the Federal Reserve to control expectations, which allows for more volatility and higher rates.

Inflation is more volatile than municipal yields

Municipal yields react slowly to changes in inflation and are not subject to the sudden, exogenous shocks that can temporarily distort consumer prices. Therefore, over the entire period, the standard deviation of 12-month changes in the BB20 was only 2.09%, versus the CPI at 2.80%.

Municipal yield changes lag inflation

Municipal yields do not rise as fast as inflation, but they also do not fall as fast. Hence, they tend to peak after inflation has hit its high water mark. For example:

• Between June 1955 and March 1957, inflation rose from a low of -0.74% to a high of 3.72%. During the same period, the BB20 yield rose from 2.41% to 3.09%, but did not peak until August 1957 at 3.54%.
• Inflation peaked (12.34%) in December 1974, while the BB20 peaked (7.44%) in September 1975.
• Inflation hit a new high (14.76%) in March 1980, but the BB20 did not reach its maximum (13.28%) until January 1982, by which point inflation had already declined to 8.39%.

The market can tolerate a negative spread

These lags have produced periods of negative spread between yields and inflation, as the inflation rate rose faster than bond yields. In subsequent periods, spreads were quite generous as inflation fell even as bond yields were increasing.

Figure 2 shows four periods in which the inflation rate was greater than the BB20 yield, and indicates when the negative spread was greatest, when the subsequent positive spread was greatest and the BB20 yield and inflation rate on those dates.

Municipal yields are more closely correlated with inflation over longer periods

The combination of the BB20’s lower volatility and its lagged response to changes in inflation indicates that investors tend to adjust the interest rate that they require based on the inflation rate over a period longer than the most recent 12 months.

We can quantify this relationship with a few statistics. The R-squared correlation between the BB20 and 12-month changes in the CPI was 0.34 over the period from January 1953 to December 2021, and the standard deviation of the spread between the two series was 2.32%.

However, if we compare the BB20 to the annualized change in the CPI over the preceding 24 months, we get an R-squared of 0.48 and a standard deviation of the spread of 1.90%. When inflation is measured over a period of 72 months, the R-squared jumps to 0.70, and the standard deviation of the spread falls to 1.24%. Figure 3 compares the BB20 yield to the change in consumer prices over the preceding 72 months.

What does this analysis mean for today?

Over the 12 months through December 2021, the inflation rate was 7.04%, up from 1.36% a year earlier. However, over the last 72 months, the annualized inflation rate was 2.78%, which compares to an annualized rate of 1.74% a year ago. If, as in the past, the BB20 yield is more likely to reflect the inflation rate of the last 72 months rather than the last 12 months, we would expect an increase of about 1.00% as a result of the recent upturn in inflation.

The fact that we have not seen such an increase is likely because (a) the Fed has implemented an unprecedented quantitative easing policy, (b) the U.S. fixed income markets are more tightly integrated with international markets than in the past, and (c) it has only been in the last ten months that the year-over-year change in CPI has exceeded 2%.

As we look ahead, much depends on whether consumer prices continue to rise at the furious pace of the last year. If they moderate, the Federal Reserve will be under less pressure to implement sharp increases in the fed funds rate, and investors’ current refusal to overreact to short-term changes in the trends of consumer prices will have been validated.

In the meantime, this analysis of the relationship between municipal yields and inflation suggests that investors take a long view of inflation, and implies that they will need to see consistently strong increases in consumer prices over an extended period before they make major adjustments to how they value municipal bonds and other fixed income securities.