Municipal Quarterly Insights 3rd Quarter 2025

 Q3 Review – Glad That’s Settled 

People were feeling good about the prospects of an established global trading regime, with a base tariff rate of 10%, and “reciprocal” tariffs on roughly 60 countries. According to the Tax Policy Center (perceived to be slightly left of center, politically) the average effective tariff rate on imported goods would be 23.1%, and over the next decade it would raise $2.7 trillion in revenue, amounting to $2,700 per taxpayer per year. In truth, these estimates are based on “framework” agreements with many of our trading partners, and much of the “sausage-making” required to get to a final implementation has yet to occur. Never mind the details, many market participants had put the worry of a global trade war behind them. 

The trade war respite gave the market psyche just what it needed to see stocks trend higher for the quarter while the bond market was digesting the confluence of a slightly softening job market, with stubborn inflation metrics, and an uncertain debt and deficit picture for the United States. The Fed found enough clarity in the mix of economic data that they lowered the target range of the Fed Funds Rate by 25 basis points in mid-September. Although they cited risks to both the inflation picture as well as concerns about a weakening employment environment, part of the goal with the move was to move toward a “neutral” stance. The elusive definition of the neutral rate may be very fluid in the near future. Currently, it is likely to be lower than previously thought due to an aging population, a change in immigration trends, modest productivity gains, and a global savings glut. Emerging technologies seem like they will turn the productivity landscape on its head, and the Covid-era savings have been spent by many cohorts that received stimulus dollars resulting in a potentially lower savings rate. 

Another dynamic that festered over the quarter was a shift to politicize the Federal Reserve. Objective people will note that there has been mission creep and political waves of influence that has hit the Fed in the past, but the Trump Administration’s efforts to fire a Federal Reserve Board of Governors member, and pressure the Fed Chairman to resign, are likely a misstep toward financial system instability. An independent Fed offers a better chance that the administration du jour doesn’t overheat the economy, or broaden the mandate, and it reduces the risk of fiscal dominance (where the central bank keeps short-term borrowing costs low to enable continued deficits – which is just another brand of malinvestment). 

The Fed’s September rate cut decision was met with some deliberation (based on recently released meeting minutes). Political pressure in the face of a Fed that values independence likely was an influence against easing rates. What may have called for assuming a more neutral policy stance was weaker employment data. In August, the unemployment rate rose slightly to 4.3%. The uptick in the unemployment rate occurred at about the same time the JOLTS Quit Rate indicated that fewer people were quitting their job, a sign that employees are of the opinion that jobs are less plentiful. Although the data indicates that the job market is softening, according to the World Bank, the 20-year average unemployment rate from 2005 to 2025 was about 6.07%, so 4.3% unemployment rate is still very robust. It doesn’t seem the current employment picture will support a Fed easing cycle to the degree that many market participants are accustomed. 

Inflation is the nagging influence that may very well be the fly in the ointment of Fed policy and the Trump administration. Whether you look at either core or headline PPI, CPI, or the PCE, inflation is stubbornly settling in around 2.7% to 3.0%. That is roughly 50% above the Fed’s preferred long-term target of 2%. Chairman Powell and just about every economist would tell you that the inflation episode that has persisted since the start of the Covid crisis is exhausting for consumers and challenging to many households. The influences of de-globalization, pressure on energy costs due to the AI datacenter buildout, potentially elevated real wage growth pressures that may come from immigration trend changes, and an unknown distribution of tariff costs may continue to exert price pressures for goods and services. Absent a recession it feels the sustained inflationary pressures will be the unexpected challenge for the Fed for the next couple of years. That may translate into cautious moves with more meaningful increments may be the normal course of action for the Fed going forward, rather than the usual tightening and easing cycles. 

Over the course of the quarter, 10-year Treasury yields moved slightly lower from 4.23% to 4.15% and 10-year high quality municipal yields also fell from a yield of 3.21% to a yield of 2.92% as the quarter ended. Taxable bond indexes experienced annualized year-to-date total returns of approximately 6% and municipal bond indexes experienced total returns of between 2.2% and 4.8%. 

Q4 Interest Rate Outlook – A Supreme Fork in the Road 

In the next month we suspect people will become much more familiar with the International Emergency Economic Powers ACT (IEEPA). On November 5, the Supreme Court will hear the case where a lower court found on a seven to four basis that the tariffs enacted by President Trump exceeded his presidential authority. There are many people that expect if the Supreme Court upholds the lower court decision, President Trump will just pursue another approach to enacting the tariffs. We would argue that it would make the most sense for the President to have started with the approach that was both expedient and had the best chance to survive court challenges. Absent a favorable Supreme Court decision, the most successful and durable approach would be through passage of a bill by a majority vote by both houses of Congress. The Trade Expansion Act allows the President to impose tariffs for national security reasons for a limited time, so it may be that the “trafficking” tariffs related to the fentanyl crisis, human trafficking, and border issues may have a stronger standing than the “base” tariff of 10% and the “reciprocal” tariffs. The trafficking tariffs are largely targeted at China, Canada, and Mexico. Given the effective tariff rates for Canada and Mexico are 25 to 35 percentage points higher than before, and since they are some of our largest trading partners, if the Supreme Court overturns the lower court ruling, even if it just applies to the trafficking tariffs, the revenue from the trafficking tariffs could raise between $145 billion to $250 billion, annually. On the high end of the estimated range of revenue, the trafficking tariffs could nearly make President Trump’s One Big Beautiful Bill nearly deficit neutral, as it has a 10-year price tag of $2.8 trillion while trafficking tariffs could raise $2.5 trillion over the same decade. However the case is decided, it appears to be the lynchpin for the success of the Trump administration’s economic policy. 

We anticipate that the Supreme Court decision has the weight to make or break the 4th quarter. Investors have driven the term premium (the yield investors demand for loaning their money out for incrementally longer periods of time) higher. It suggests they are nervous about the amount of federal debt outstanding, persistent deficit spending, political division which may make for more extreme and diametrically opposed outcomes from each of the party’s “solutions” to the problems at hand. There are numbers that support some introduction of caution. According to Bloomberg, the current interest cost for the U.S. relative to total tax revenue has climbed to approximately 17.5%, while the balance of the world pays on average less than 10% in interest cost relative to total tax receipts. The number for the U.S. is nearly 70% higher than where it was a decade ago and we haven’t had numbers this high since the early 1990’s. The U.S. is not alone on the assumption of and outsized debt burden. Many developed market economies are seeing a deterioration in liquidity. Reduced liquidity with higher interest payments can be a predecessor to the dreaded “doom loop” where a government is forced to borrow more money at ever higher yields to pay interest, which can result in a cycle which can compound the problem. Profligate spending isn’t unique to the U.S, many developed countries have seen legacy debts pile up. Contributing to the current state is the unholy matrimony of many developed market issuers having the luxury of issuing bonds in the currency they print, and the pain-free hyper-low-interest rate environment that coincided with the Covid pandemic. Unfortunately, the inevitable pain was deferred until interest rates normalized. That’s where we find ourselves today, picking up the tab and making difficult decisions related to the excess spending related to the pandemic, and the two decades that preceded that seminal episode. 

The Fed has reduced the pace of Quantitative Tightening to a pace of $5 billion per month and the natural portfolio “roll off” of the Fed’s Mortgage-Backed-Security portfolio results in its balance sheet shrinking by roughly another $17 billion per month. The effect it has is to put downward pressure on bank reserve balances. This in itself isn’t alarming as the Fed had a goal of taking bank reserves from being “abundant” to being “ample.” In that transition there will be a delicate balance of finding the right stopping point. Go too far and funding markets can misbehave and the Fed will have to jump back in to shore up reserves or funding mechanisms and if they wait too long the chill can spread to the credit markets. A related metric to watch is the reserves-to-bank-liabilities ratio. We currently sit below 14%, a rate not seen at that low of a level since early 2020. For added context, that measure of bank reserve health made a steady decline from a number closer to 16% in the period between 2015 through 2018, and fell to 14% in 2018 and declined below 10% in 2019. As part of the Covid response, the number exceeded 20% in 2021. In 2018, when we got to the current level, it seemed to precipitate the rise in money market, and other short-term borrowing rates. Another sign of potential stress is that repurchase agreement (repo) rates are seeing an increasing yield spread as compared to the Fed funds rate. Dallas Federal Reserve President, Lorie Logan points to the significance of the repo market because it entails more than $1 trillion of trade volume per day, which sees a full order of magnitude more than the Fed funds market. Admittedly, this “funding stress” is both nuanced and possibly premature. Again, the Fed wants to take bank reserves to an “adequate” position, and in doing so there isn’t a prescribed point at which it is obvious to stop. It may be a “management by feel” exercise, but in the event they go too far, there could be a temporary point at which markets sputter and a Fed backtrack may either support or shake the confidence of the markets. 

Although the Supreme Court decision may be more nuanced that a simple binary solution, where tariffs are either allowed or disallowed, gaming the two scenarios may offer a window into what faces the market. The themes of de-dollarization, the rise in gold and Bitcoin values, and the increase in the term premium suggest the market has concerns. We have talked about projections related to the debt-to-GDP ratio of the United States. It seems like the Supreme Court decision will directly determine the path of our future. Tariffs are a broad-based tax on consumers. It is speculated that the burden of the cost falls on the shoulders of consumers, but as mentioned last quarter, business efficiencies and possibly profit erosion, both foreign and domestic may absorb some of the impact. To a degree tariffs are a shared revenue burden. If tariffs are allowed to stand, it may be an unexpected tool to get our deficit in check and move toward a path of a sustainable debt burden. It would likely temper the term structure increase, expected Treasury issuance could decrease, and the dollar should have an impetus to appreciate relative to other global currencies. Many positives come from the scenario where tariffs are upheld and the negatives for economically challenged segment of the population can be addressed as needed. If the Supreme Court decision goes against the Trump Administration (ignoring a successful workaround), projected deficits related to the One Big Beautiful Bill Act and the potential deal-making related to the government shutdown, will shock the markets. The term premium may worsen, de-dollarization should expand, anticipated issuance of Treasuries could cause higher borrowing costs and Treasury auction challenges, and the onshoring economic lift that the tariffs have encouraged would diminish. In general, we will have strained our relationships with allies with nothing to show for the expended political capital. In short, it would very likely be a very bad day for bonds. 

Beyond simple asset class performance, the absence of tariff revenues will likely push the resolution of our deficit spending crisis out to the point where we don’t get to make choices in an orderly fashion, at a point the funding markets will make the tough decisions for us. Artificial intelligence froth or not, it may trigger a “risk off” moment for the financial markets. The decision in November and any credible workarounds will impact the financial markets, it may seep into Fed policy, consumer sentiment, and the trajectory of the United States. 

Earlier we talked about the neutral rate being lower due to several factors, including a productivity lull. Although less immediate than the status of tariffs, the progression of artificial intelligence will disrupt many aspects of our economy. Productivity could go through the roof, which would suggest a dramatically higher neutral rate for Fed policy. The potential impact may call into question the portion of the Fed’s mandate aimed at full employment. Putting on our “futurist” hat, the combination of AI and humanoid robot technology could fundamentally change the employment environment from a top down and a bottom-up perspective, respectively. The massive improvement in productivity may collide with elevated unemployment levels such that the inflationary and disinflationary influences on the economy may demand dramatic changes at the Fed. If our economy is a balance between the value of capital and the value of labor, AI seems to further the value of (immense amounts of) capital and it may diminish the value of labor. Never mind people calling for AI (AGI and ASI, to be more specific) to possibly precipitate an extinction level risk for humans, the social, tax policy, security, and governance challenges that AI will probably expose humanity to are numerous and of a magnitude that the currently divided population isn’t capable to address. It is a thought exercise worth batting around. What will be the savings rate for future college graduates with above average intelligence with limited job prospects? Will there be a glut of savings and investment (because capital may be more valuable than labor) or a lack of a savings discipline (because if you don’t have decent career prospects, you may live for today). Will an increase in the divide between the wealthy and the working class become more exaggerated? Do diametrically opposed political parties result in dramatic policy swings as we try to grapple with a technology that is beyond our comprehension? Nobody can know what the near future holds but it seems like the convenience of having an AI assistant will come at a human cost. 

Municipal Market Developments – The Good, the Bad, and the Ugly 

Year to date municipal returns have been coupon-like which isn’t bad considering we are near the highest yields generally enjoyed since before the Great Financial Crisis. Despite the section title, we expect munis broadly will be the sleepy backwater, in terms of generating nice returns per unit of actual risk of loss (meaning a continuation of a very low default ratio). The term structure dynamic mentioned earlier flows through into the muni market, which translates to nice yields for longer-term bonds. The liquidity premium that munis often experience make them even more interesting relative to other sectors of the fixed income market. Munis out in the 30-year area can be found with yields of 4.5% for high quality issuers. For high-bracket investors, that likely results in a taxable equivalent yield that may exceed junk bond corporate bond yields (consult your tax advisor for tax advice, ACG does not provide tax advice). The elevated current coupons offer a degree of cushion against the risk of rising rates, attractive taxable equivalent yields if yields go sideways, and if bond yields fall a person should enjoy returns that exceed the coupon. The good news is that longer municipal bond yields offer historically attractive yields which should offer an above average return experience for investors at the current rates. 

The bad news is likely to generate phone calls, but don’t mistake credit deterioration for the genuine risk of default. U.S public school districts are increasingly tapping into reserves as they face financial challenges, namely the reality that Covid funds would appropriately disappear following the conclusion of the pandemic, along with lower headcounts for schools that are not competitive or appealing to students with alternatives. As of June 2025, the number of negative rating or outlook revisions assigned to school districts increased 40% on a year-over-year basis. Nearly a third of the schools rated by S&P had operating deficits in 2024 as compared to 17% in 2021. Schools are under budget pressure, but they are an essential service, and the populace will support the great economic escalator, education. We are just about to enter our annual credit assessment of credits to which ACG clients are exposed. We have seen some deterioration of school district credits, but the ebb and flow of creditworthiness may be more likely to reduce liquidity of school bonds, rather than materially increase the risk of loss on a credit. In the end it may present an opportunity to buy quality issuers at enhanced yields as people throw the baby out with the bathwater. 

Now for the ugly. The sectors that we have implored readers to avoid remain the same. Small private colleges, some Chicagoland area issuers, and certain hospitals and clinics are heading for a rough patch. Huron Consulting Group estimates that reduced headcounts will dwindle and that as many as 370 private colleges in the U.S. will either close or merge with another institution. The national birth rate fell in 2007 and hasn’t recovered. Huron further speculates that as many as 430 additional institutions, serving 1,200,000 students will face “moderate existential threats.” Not to beat a dead horse, but the value of a non-descript liberal arts degree, in the face of AI knowledge gains and efficiency, offers questionable economic return on the investment. Chicago area municipal issuers often don’t disappoint in their generosity of examples of how not to run a major metropolitan area. Chicago public schools, already under pressure from a major budget gap added an additional burden by making a late contribution to its pension fund. By late August, the District accumulated nearly $2.4 million in late fees on a $734 million deficit before a late August deadline. The teachers pension plan is 50% funded and thanks to a new law enhancing benefits, the Chicago police and fire pensions are only 18% funded. The richness of past retirement benefits glaringly robs the current populace of quality-of-life standards that previous residents enjoyed. Lastly under the “ugly” classification, small and rural hospitals are experiencing tough times. Nearly half of country hospitals are operating at a loss. 

Approximately 200 rural hospitals have closed over the past two decades. The main challenges for small and rural hospitals are high fixed costs, poor reimbursement rates, and extremely low patient volumes. Muni market investors in the private college space, the hospital area, and Chicago issuers are likely to see a pickup in signs of serious stress. It is important to remember this is a small subset of the municipal bond market and one that ACG typically sidesteps when constructing portfolios. 

Strategy and Summary – Enough Already 

It has been a year of exhausting “wait and see” moments. Now it is not much different compared to all the other sources of instability. Perhaps this time it is more of a “jury is out” moment. If tariffs are allowed by the Supreme Court, the fear in the market may subside and the net effect may be the removal of uncertainty and fear which would likely reduce the term premium, and with it intermediate and longer-term bond yields. If tariffs are disallowed rates will probably rise and, the fear in the market should increase the term premium and the U.S. and yields (the cost to fund our debt and deficits). Worse yet it may take us to the precipice of the doom loop where debtor nations (starting with the U.S.) borrow money to pay Treasury debt. 

As the Fed cuts rates once or twice more in 2025, the yield curve should experience a continuation of the “bull steepener,” with short rates moving lower than the intermediate part of the yield curve and the long end of the curve will be anchored near current levels until some clarity about the federal deficit and supply of new debt become clearer. Short-term bonds continue to be a stabilizing part of our strategy. There is a lot of yield/return for the modest risk being assumed with short term bonds and cash equivalent securities. Historically, when bond yields are at elevated historic rates, it is a good time to “go long” in bonds. This Fed easing cycle is not your garden variety cutting cycle, and when considered alongside the possibility of a binary interest rate outlook makes longer bonds a prudent choice but also one that is very uncomfortable. There are no easy returns to be earned in the financial markets. It feels like a stock pickers equity market which may also have a healthy dose of what has worked to this point in 2025 continuing to perform, and bond managers will be nimble to navigate this treacherous market. The price of overconfidence may be great over the next three months.

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