Municipal Quarterly Insights 1st Quarter 2026

Q1 Review – Tariffs Rejected and Military Pursuits

Interest rates rose over the course of the first quarter of 2026. At the margin, some of the moves may be attributed to stubbornly persistent inflation. Labor market metrics have been mixed but by historical measures, the employment environment remains robust. The Fed’s own “dot plot” reflects a median forecast of one rate cut in 2026 and another cut in 2027. In contrast, the market had been expecting up to two rate cuts in 2026, more recently it expects that there is nearly a 50% chance of a rate hike in 2026.

As of late March, the labor market showed mixed picture. While the unemployment rate declined to 4.3%, the improvement was attributed to 396,000 fewer people in the labor force. Concurrently, the JOLTs data showed that there were 6.9 million jobs available for 7.2 million unemployed people, or 0.96 jobs per job seeker. Compared to long-term averages, the unemployment rate remains historically low. Wage growth has declined to an annualized growth rate of 3.5%. If wages can outpace inflation, resulting in real wage growth for consumers, Fed policy may be focused on the price stability goal of their dual mandate.

Over the last half of the quarter, many inflation measures came in hotter than the market was expecting. Looking at both the headline number and “core” numbers (which exclude food and energy) of the Consumer Price Index, the Producer Price Index, and the Personal Consumption Index, many of the year-over-year measures came in at or above the consensus forecast and the prior reading. Consumer inflation measures are generally in the range of 2.4% to 3.3% and producer inflation metrics suggest price increases are growing by 2.9% to 3.9%. Most of the measures reported in March were as of February, so the oil price spike and supply chain disruptions caused by the military conflict with Iran were not included in the elevated inflation numbers. Absent oil price increases resulting in demand destruction, sticky prices seem like they will continue to be at the top of mind for consumers.

Solid employment numbers and sticky inflation data explain the “what” aspect of higher interest rates and future expected Fed policy. The “why” may center on the rejection of President Trump’s tariffs by the Supreme Court and the repercussions of the military action between the U.S. and Iran. Striking down the tariffs propelled the U.S. deficit closer to $2 trillion, against the backdrop of a federal debt of $39 trillion. That level of indebtedness results in an annual interest cost of $1 trillion, roughly twice interest cost as recently as 2022. The current state of the federal deficit, mounting federal debt, and the dismal political and fiscal situation has investors concerned about the future value of long-term U.S. Treasuries.

Geopolitical developments have further compounded inflationary pressures. Military actions, alongside a roughly 50% increase in oil prices, have placed upward pressure on commodity markets and revived concerns around supply chain disruptions. An estimated 20% to 30% of global transit in key commodities—including helium, oil and gas, fertilizer, and sulfuric acid—passes through the Strait of Hormuz. Prolonged disruption could materially impact agricultural output and global pricing dynamics. In addition, attacks on civilian and energy infrastructure may impair productive capacity for years. Oil price increases impact consumers and their disposable income. Supply chain disruptions, influenced by the length and outcome of the war, will also likely cause price pressures. The inflationary waves introduced by the conflict with Iran may cause challenges for both consumers and fixed-income investors.

Year-to-date, 10-year Treasury yields increased, moving from 4.17% to 4.32% while 10-year high quality municipal yields rose from a yield of 2.72% to a yield of 3.07%. Taxable bond indexes have generated flat to modestly negative returns (0% to -0.25%), while municipal bonds have declined between 0% and -1.0%.

Q2 Interest Rate Outlook – The Good, the Bad and the Ugly

Last quarter we opined on the various Supreme Court tariff scenarios. The Court’s decision was to essentially strike down nearly all the sweeping “reciprocal tariffs” as well as the “trafficking” tariffs. Essentially, all the tariffs imposed under the International Emergency Economic Powers Act were disallowed, while leaving in place tariffs based on national security and unfair trade practices. Based on late 2025 collections, the disallowance of the tariffs means an annualized revenue stream of between $300 billion and $360 billion is either gone, or it will be attempted to be recreated through a patchwork of alternative workarounds. Absent the political will to broadly raise revenue, or cut expenditures, the lost tariff revenue is significant. Our forecast that trafficking tariffs would stand, along with the $2 trillion deficit top the list of what was ugly last quarter.

In terms of beauty being in the eye of the beholder, one constructive development has been the administrative handling of tariff refunds. Contrary to initial expectations of prolonged litigation, the Administration has taken steps to streamline the process, including revoking the original executive orders, reducing legal uncertainty, and implementing a digital claims infrastructure. While this approach may expedite disbursement of funds, it is worth noting that tariff costs—estimated by the Council on Foreign Relations to have been borne 55% to 67% by consumers—will largely be refunded to importers of record. This transfer from consumers to the importers may result in a near-term profit boost for large retailers and some amount of pass-through stimulus for consumers.
 

Our last bit of “ugly” forecasting last quarter involved a “sunshine, rainbows, and unicorns” scenario where politicians got together (stay with me) and made the tariffs permanent in exchange for an extension of the Covid-era ACA subsidies. No grand bargain occurred and if anything, the two major political parties seem more diametrically opposed than ever. In a world that is not binary, we may be nearing a point where a simplistic worldview and solution set is inadequate for the severity of the problems we face. Childlike avoidance of existential threats, self-dealing of our representatives, and short-termism are our shortcomings that are truly ugly and a dereliction of our stewardship of this economy.

Although “good” news seldom garners many headlines, there are many things going well with the U.S. economy. The tensions with Iran caused a pullback in stock market prices, but considering how much impact the region has on global commerce, being roughly 2% to 3% below the record high values for the indexes speaks to the resilience of the U.S. economy. Corporate earnings are projected to grow approximately 17.4% for 2026, partially supported by productivity gains from AI. As stated earlier, the labor environment is also strong by many measures. Real wage growth, although modest, is positive so workers are gaining ground relative to inflation. When people have jobs and their wages allow them to enjoy improved purchasing capacity, the foundation of the economy is currently solid. Further supporting near-term growth of the U.S. economy are the stimulative aspects of President Trump’s One Big Beautiful Bill Act (OBBBA). In addition to business incentives, which Principal estimates will add 0.6% to 1.1% to 2026 GDP, the provisions on tips and overtime are expected to add $50 billion to $80 billion in annual disposable income through 2027. The world may be in flux, but the U.S. economy has many bright spots.

We already touched on some of the “bad” aspects of the economy, but persistent inflation, unending deficits, and war-related supply chain shocks are the main current challenges. High energy prices function as a regressive tax, disproportionately impacting lower-income households. According to the U.S. Energy Information Administration, each $1 per gallon increase in gasoline prices reduces non-energy consumption by approximately 0.3% to 0.5% of GDP. Given the historical correlation between energy production and global economic output (roughly 0.87 over the past 40 years), sustained disruption could materially dampen growth. The longer the war persists and the more widespread the infrastructure damage, the worse the spillover may impact consumers and economic activity.

An unexpected negative development might come from a theoretical and technical inflationary influence. Many Fed governors have recently indicated that they are comfortable with current central bank policy rates. It indicates that policymakers believe the Fed Funds Rate is near a neutral position. The neutral rate (also called R*) is the theoretical policy rate that is neither stimulative nor restrictive in its influence on the economy. The illusive R* is important because it is a factor in the Fed’s decisions. Several market-based estimates of R* suggest the current neutral rate ranges from 3.3% to as much as 4.35%. There tends to be a strong relationship between the 2-year Treasury yield and the subsequent change in the Fed Funds Rate. Currently, the 2-year Treasury yield is higher than the effective Fed Funds Rate. It suggests that current policy rates may be stimulative, which could exacerbate inflationary pressures. When considered with declining savings rates, which tend to be inflationary, along with the OBBBA stimulus and the wealth transfer to importers, there is a legitimate chance that inflation may trend even farther from the Fed’s long-term goals. Reasons why the neutral rate may have trended higher include a surge in productivity from AI, the persistence of inflationary pressures, or a decline in the appeal of government bonds. Although the Fed can correct policy, currently they may be positioned to stoke inflation, which is not the expectation of the market.

Our “Good, Bad, and Ugly” section wouldn’t be complete without diving into private credit. We mentioned private credit as an area of concern in our Q1 2024 edition of Insights. Following the Great Financial Crisis, non-bank financing entities grew at a rapid pace, now totaling $2 trillion in assets. The current situation is a result of an opaque asset class, inappropriately allocated investors, and “Jonny-come-lately” fund managers. The asset class is opaque in that some investors don’t know what they hold, and for that matter, some investment managers may not have much of an idea either. One example is a $1.8 billion loan to Medallia Inc., a software company, where one of the largest private credit managers has the loan value at $0.97 and another major manager priced the loan at $0.77 (so on a $100,000 investment, one manager values it at $97,000 and the other has it at $77,000). There are reports of far more dramatic loan “mark” discrepancies. Part of the issue is the managers themselves report the value to investors. If fees are charged on market value, there may be a conflict of interest that is difficult to avoid.

Sadly, some private credit investors, both individual and institutional, are accustomed to public markets, where you can get out of an investment almost immediately. Private credit funds have liquidity windows, or limits on the amount of liquidity they must offer investors on a quarterly basis (with 5% per quarter being the most common). If investor demand exceeds a set threshold the fund can impose a gate or suspend redemptions until the market stress subsides. In the first quarter of 2026, investors sought to withdraw approximately $13 billion from a dozen of the largest funds. As a result of the gates being imposed, nearly $5 billion is trapped in the funds. The desire for liquidity isn’t due to a current spike in defaults on the underlying loans. Moody’s estimates that as of January, if you lump actual defaults in with “extend and pray” solutions where struggling borrowers “pay” debt by either extending the amortization of their debt or Payments in Kind (paying off debt with new debt), the default rate on private credit is 5.8%. UBS has one of the most pessimistic estimates on the street, with a belief that defaults on private credit could reach 15% if AI causes an “aggressive” disruption among corporate borrowers. A lot of the loan terms are within eight years, so the headline-grabbing number seems like a remote possibility. We expect that since some investors feel trapped, there will be investment outflow pressure for many quarters, if not years. It should mean depressed returns as some investors work their way through the exits. A positive development should be improved underwriting standards on the part of the managers and stronger loan holder protections (covenants). Near term pain for current investors and longer-term gain for investors for whom the asset class is appropriate.

Variability in quality of the investment managers is another aspect that needs to get flushed out of the private credit space. Inexperienced managers, without the staff to “work out” distressed loans, have been eager adopters of kicking the can down the road solutions. Some fund-of-funds strategies and fledgling managers in the private credit market have a veneer of talent which results borrowers dictating terms as they are failing, and investors likely taking a back seat to convenience and firm profitability. As investors and managers who may not be a good fit for private investments work their way out of the market, returns may be challenged. In the end, the private credit market should be strengthened and the liquidity windows and gates that are causing panic now may be the differentiator that benefits investors for whom the asset class is appropriate. As the disorder causes credit concerns and firms try to grab headlines, there may be temporary spillover effects into credit spreads in the public debt markets. We are nearly a standard deviation “tight” with investment grade corporate bond spreads, so anything that approaches an “average” spread we see as an opportunity to add credit exposure.

The market expects GDP to decrease as 2026 progresses, while unemployment rises and inflation moves higher as compared to the first quarter. Concerns about oil prices and the uncertainty of war could suppress economic expectations, causing Treasury yields to temporarily decline. Immovable deficits, supply chain disruptions, and several sources of stimulus have a good chance of carrying Treasury yields higher. We see a floor on the 10-year Treasury of roughly 4% and an upper bound of 4.80% for the remainder of 2026.

Municipal Market Developments – March Madness

Last quarter we noted that the relative value of municipal ponds as compared to like-term Treasuries was below average. March gave municipal bonds the “opportunity” to remedy that situation, losing roughly 2.5%, whereas Treasuries lost 1.8%. It was the worst month for munis since September 2023. The market had strong supply of new issues expected at the same time we were heading into challenging seasonal dynamics. Leading up to tax payments, municipal bond fund investors often sell holdings. Supply was strong but the fund outflows have been subdued. From this point it appears the supply/demand environment for munis will be more balanced for much of the rest of the year.

Our estimate had been that municipal bond indexes will earn “coupon-like” returns in 2026 (approaching 3%). The rough start to the year and our outlook for some surprising sources of stimulus and inflation make 2% to 2.5% more likely. A more interesting entry point would be if deficit concerns or spillover from the private credit panic leaches into the broader credit markets. The municipal bond market is susceptible to liquidity crunches. Although the municipal market is certainly less “rich” it isn’t “cheap” at current levels. When bond market yields spike you “buy the market” over holding out for “perfect” execution. We are not there yet but we see our role to explain potential strategies ahead of the market moves that call for action.

As we strive to make municipal bonds a topic at more dinner parties, this next section will tie prediction markets in with AI and municipal credit risk assessment. ACG has been conducting in-house credit research on municipal bonds for nearly 20 years. The market has evolved over that time from having to request paper copies of financials to electronic delivery of issuer information. We still must chase finance directors and county clerks down for the occasional update. A challenge to making credit analysis actionable in our effort to get the most yield for clients is how stale data can be for municipal issuers. Much of the analysis is backward-looking and relative to like issuers. We follow roughly 700 municipal issuers, so we get a good sense of the relative strength between like issuers, trends in certain states, and challenges that translate into many seemingly disparate issuer types and geographies.

We augment and reconcile our work with major rating agencies. Beyond that we have embarked on the creation of a new set of credit assessment models that are more dynamic in their weighting of variables, based on the predictive value of a change in variables and subsequent changes in ratings. Whereas our long-time models are intended to measure the risk of default, the new models are intended to be nimbler and get ahead of the risk of a downgrade. Both perspectives have value. AI is helping to manage and digest all the data needed to attempt to get ahead of rating actions. Eventually, prediction markets could offer forward-looking signals to our assessments. In the corporate bond side of our business, we incorporate credit default swap information and to a lesser extent equity market signals to offer a forward-looking influence on our evaluation. Prediction markets could eventually offer increased price transparency to the municipal market and even offer a metric to estimate downgrade and default probabilities and hedge the risk if a manager wanted to reduce the credit risk without having to sell a bond and alter desirable portfolio characteristics. Who knew municipal bonds could be so cutting edge and exciting?

AI can’t fix the challenges that Chicago faces. During the quarter, Fitch Ratings lowered Chicago’s credit rating down a notch to BBB+, and they have a negative rating outlook. The firm cites ongoing deficit spending, one-time solutions and political discord as reasons for the downgrade. They have crippling growing pension costs and like many government bodies, they just don’t seem to be able to tell constituents the bad news. They mismanaged their fiscal house and the population that remains is picking up the tab. The standard of living won’t be what it was in the past. A recent debt issue had to be partially shelved due to market conditions and appetite for Chicago’s debt. Proceeds of the sale were to finance expenses such as firefighter backpay and payments for judgements and police settlements. Borrowing to cover the interest cost on borrowed funds (capitalized interest) and structuring the debt so future payments are greater than near-term payments further places today’s burden on future residents. Cashflow borrowing, debt gimmicks and population decline are the marks of a failing municipality. To expedite the demise, Mayor Brandon Johnson is hoping to fill a $1.2 billion deficit by reinstating a monthly tax on large employers for each worker they employ – it should be called the “Jobless in Chicago Tax.” There is a lot to love about Chicago, but unfortunately it looks like a Detroit-style example of how not to run a city.

Strategy and Summary – A Resilient Economy Meets Uncertain Times

The U.S. economy remains fundamentally resilient, supported by low unemployment, strong corporate earnings, the promise of AI productivity gains, and ongoing fiscal stimulus. However, these strengths are counterbalanced by persistent inflation, elevated deficits, and geopolitical uncertainty. The Fed seems to think that they are at a neural stance but there is a risk they are in an accommodative position, which may be made more stimulative through the temporary QE program. We expect that the 10-year Treasury yield will explore a range from 4% to 4.80% in 2026. The wildcard that will drive the markets is the degree and duration of the supply chain disruption. It seems the U.S. is somewhat insulated from related shocks, but we live in a global economy so pain will surely be felt by consumers.

Unless an unthinkable war scenario and previously unseen oil prices come to pass, we can’t see a scenario that would make a Fed rate cut likely. Bond yield spreads are historically stingy and there is a real risk of another wave of inflationary pressure. It doesn’t seem like a prudent market in which to be a hero. Market yields remain on the high side of what we have seen for the past 20 years. A high-quality bias and neutral to slightly long duration position makes sense. We expect that the environment for bond heroes has yet to come.

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