Last week, Moody’s Ratings downgraded the U.S. government’s credit rating from Aaa to Aa1 citing rising government debt. The 10-year U.S. bond yield at the time of this writing was 4.47%. It jumped to 4.55% at the open this morning.
Rising debt servicing costs and a growing budget deficit are not surprising. However, we believe these factors will cause the yield curve to continue to steepen.
Moody’s downgrade wasn’t unexpected but comes amid heightened market volatility. The federal deficit is close to 6% of GDP. Moody’s expects the number to widen to 9% of GDP by 2035. The three horsemen here are:
As we get more desensitized to headline risk, so is the case with U.S. credit downgrades. According to Treasury data as of March 2025, foreign demand for U.S. debt has not decreased. However, China’s ranking as a U.S. debt holder has changed. China dropped to the third-largest holder of U.S. debt (after the U.K. and Japan, respectively).
Currently, foreign buyers account for one-third of the U.S. government debt.
There is good news for municipal investors this week. As expected, the tax bill draft did not cut out tax exemptions for muni bonds. Under the threat of muni exemption, issuers came out in force to defend volume for issuance. With this respite, bond sales can be spread out through the year. However, as is the theme, we expect muni exemption to be in the news until the budget is fully passed.
The proposed tax bill (as currently drafted) would triple federal deductions for state and local taxes (SALT) up to $30,000. An offshoot of this could be that tax-exempt debt for California, New York, and New Jersey becomes less desirable. Most of these states command a premium when it comes to tax-exempt debt. The increase to the SALT cap will likely lead to higher spreads and corresponding attractive yields for the “specialty states’” debt.
CHANGES IN RATES
The Treasury market rallied in yield. This week, the market should show its reaction to Moody’s downgrade of debt.
Muni yields remained range-bound last week.
The lower ratios illustrate the municipal bond market’s firmer footing.
Corporate yields remained unchanged for the most part last week.
As Moody’s downgrades U.S. debt based on rising federal deficits, Congress seems to be focused on increasing federal debt. The Joint Committee on Taxation has estimated the total cost of the bill to be $3.8 trillion. Hallmarks of the bill are:
This budget's entitlement spending is on the chopping block. States are getting ready to cut their Medicaid and food benefit programs. The bill should reach the House Ways and Means Committee by this Tuesday. The goal is to pass the legislation by Memorial Day.
In international news, tariff negotiations between the U.S. and China continue, dominating the market, even though reciprocal tariffs are on a 90-day hiatus. With regards to the Russia-Ukraine War, Putin believes that Russia can gain full control of Ukraine by the end of the year. European political leaders are getting nervous about President Trump’s ability to negotiate peace for these two countries.
The 5-year breakeven inflation rate finished the week of May 16 at 2.42%, 3 basis points higher than May 9. This number has been slowly creeping up over the last month. The 10-year breakeven inflation rate finished the week at 2.34%, 5 basis points higher than last week.
As of May 16, the 10-year quality spreads (AAA vs. BBB) were 0.97%—1 basis point higher than last week’s reading (based on our calculations). The long-term average is 1.69%.
Investment grade spreads are very tight at 0.78%, same with high yield at 2.95%.
Money Market Flows (millions of dollars)
Overall, all money market funds saw a drop in inflows last week.
Mutual Fund Flows (millions of dollars)
Last week saw mixed cash flows for bond funds.
ETF Fund Flows (millions of dollars)
ETF asset classes saw a net increase in inflows this week, with a drop in munis.
The supply of new muni bond issues is expected to be closer to $10+ billion this week. This follows the previous three weeks’ large calendar of $10+ billion.
U.S. government debt took a hit from Moody's downgrade. This week should show the market’s reaction to that downgrade. Tax bill drafts have been positive for munis, seeing that the threat to tax exemptions seems to be off the table for now. Also of note: the proposed SALT cap increase. The deadline to pass the bill is Memorial Day. Please note: there will not be a “Week in Review” next week in honor of the holiday.
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