Municipal Quarterly Insights 3rd Quarter 2026

Q3 Review – High Prices and Higher Yields

The deterioration in prospects for peace in the war with Iran has turned what markets initially viewed as a transitory energy-price shock into something more persistent. Since the start of the third quarter, Brent crude has risen more than 40%, to above $100 per barrel. Higher gasoline and diesel prices are also hitting consumers directly. Gasoline has historically represented roughly 2% to 5% of household disposable income, depending on prices and consumption. The economic burden is meaningful, but the psychological effect may be even broader. Diesel costs may matter more to the inflation outlook because freight costs are embedded throughout the supply chain. Last quarter, we suggested that the conflict was unlikely to be resolved before the midterm elections. The administration’s recent posture appears consistent with that view. Absent a material diplomatic or military shift, disruption around the Strait of Hormuz is likely to remain a global market risk.

During the past quarter, inflation concerns and affordability pressures returned to the headlines. The second-order effects of record diesel prices are particularly important. Higher fuel costs raise the expense of moving goods, while smaller trucking operators may be unable to pass the full increase through fuel surcharges, potentially reducing capacity. Farmers also face higher costs to plant, harvest, and deliver crops, adding pressure to grocery prices. Elevated fuel prices therefore affect consumers directly and can also weigh on sentiment. The divergence between core inflation, which excludes food and energy, and headline inflation illustrates the Fed’s challenge. In August, headline CPI rose 3.4% year over year, while core CPI increased a more manageable 2.4%. The Fed’s preferred measure, the Personal Consumption Expenditures Price Index, showed headline inflation of 3.4% and core inflation of 3.0% year over year. Over the three months through August, however, headline PCE increased at a 1.0% annualized rate and core PCE at a 2.0% annualized rate, suggesting that underlying inflation pressure may be easing even as energy prices remain a visible risk.

Fuel-cost headlines and interest-rate concerns weighed on consumer sentiment. Yet the U.S. consumer remains unusually resilient. Anxiety about the cost of living pushed consumer confidence in September to its lowest level since 2014, while August consumer spending increased at its fastest pace since late 2024. Households increased spending on big-ticket items such as vehicles and home furnishings despite elevated financing costs and weak real wage growth. Stock market gains may be supporting some households, but part of the spending appears to be coming at the expense of saving. In August, the personal saving rate declined to 4.1%, its lowest reading since 2022. Betting against the U.S. consumer has historically been a losing proposition: over the past 50 years, real GDP contracted on a quarter-over-quarter basis in only 21 of 200 quarters. As long as credit remains available and lending standards do not tighten materially, it may still be premature to bet against household spending.

Fixed income yields were the defining story for the third quarter. Markets reacted to the combined funding needs of developed sovereigns and the rapidly expanding issuance associated with AI infrastructure. That demand for capital is arriving while household and global savings rates are relatively low, pushing borrowing costs higher. We discuss this dynamic in more detail below, but neither the pace of AI investment nor the supply of government debt appears likely to change materially before the end of 2027. Capital may therefore remain expensive, with persistent upward pressure on yields. September was particularly difficult for bondholders and pushed many bond-market sectors into negative year-to-date territory. Short-duration bonds provided the most effective protection from the sell-off.

During the quarter, the U.S. Treasury expanded its buyback operations, purchasing less-liquid, off-the-run securities from dealers. The program supported liquidity in longer-dated Treasuries and freed dealer balance-sheet capacity, while the Treasury’s broader financing mix continued to favor shorter maturities. Early messaging from Treasury Secretary Bessent—most notably his comment that Treasury was “the house”—was more combative than constructive. The program has since been framed primarily as a market-liquidity tool. Mr. Bessent is a serious policymaker, but the initial rhetoric was a misstep. With gross federal debt now above $40 trillion, credibility, efficacy, and disciplined communication matter more than bravado.

The Fed unanimously raised the federal funds target range by 25 basis points in mid-September, to 3.75%–4.00%. Chair Kevin Warsh described the move as removing a dose of accommodation rather than beginning an aggressive tightening cycle. The decision indicates that the Committee viewed policy as insufficiently restrictive given persistent inflation. The September dot plot showed a median expectation of one additional 25-basis-point increase in 2026, with some probability of another hike in 2027. At the time of writing, market pricing assigned a 20% probability to an October increase and a higher 80% probability of a December move.

Over the quarter, the 10-year Treasury yield rose from 4.46% to approximately 5.28%, while the 10-year high-grade municipal yield increased from 2.89% to approximately 4.13%. Our 2026 forecast called for the 10-year Treasury yield to remain within a 4.0% to 4.8% range. That forecast, which began the year directionally different than consensus, will still prove too low if current levels persist. Taxable bond indexes have generated year-to-date losses of roughly 2% to 3%, while municipal bond indexes are down approximately 3.5% to 5.5%, depending on duration and credit exposure. Our expectation for coupon-like returns is not likely to end up being correct. If political gridlock reduces concern about additional fiscal expansion, however, flat full-year returns remain possible.

Q4 Interest Rate Outlook – Time to Hit the Brakes?

Several themes from last quarter’s Insights subsequently drew market attention. At the start of the year, we argued that the neutral rate was higher than the prevailing federal funds rate, supporting our call for renewed tightening while markets still expected additional cuts. We also questioned whether future AI-related revenue could justify the current pace of capital spending. Our most prominent theme, however, has been crowding out. All three warrant further examination. The Fed has largely validated the view that less-accommodative policy was appropriate. At the same time, policymakers and AI-industry leaders have increasingly called for stronger safety standards. Reports that advanced models can identify software vulnerabilities, behave deceptively, or escape their “sandbox” deserve scrutiny. Critics also argue that some closed-source developers may favor regulations that widen their competitive moat against lower-cost open-source models. Liability standards for misdeeds caused by AI systems may become part of the policy response. The debate will intensify, but political gridlock may make it difficult to balance AI dominance and public safety.

We have discussed crowding out in the debt markets at length, and it has now become a central market concern. The conventional theory holds that elevated government borrowing raises financing costs for corporations and erodes profit margins. We have argued that the relationship may now run in both directions: heavy corporate borrowing, particularly for AI infrastructure, can also increase the government’s funding costs, while persistent deficits and rising debt-service expense add further pressure. This competition for capital is occurring as savings rates decline, and the global savings glut of the prior decade recedes. Some AI-related borrowers may be relatively insensitive to whether financing costs are 5% or 6%. Microsoft, for example, has reported cloud gross margins above 60% and revenue growth approaching 30%. For a business with that growth and profitability, a modest increase in borrowing costs may have limited effect on margins. Most governments have far less flexibility. Their ability to raise revenue or reduce spending is constrained by politics, demographics, and existing commitments. Political polarization makes the challenge more complex by turning the suite of available solutions into a couple of disheveled closets.

The debt challenge is not unique to the United States; several developed economies face persistent deficits and rising debt burdens. France has attracted the most attention. Populist politician Jean-Luc Mélenchon has advocated effectively canceling 18% of the country’s sovereign debt. Such a policy would amount to a default or forced restructuring, not simply monetary financing, and would likely seriously impair market access, widen spreads, and increase inflation and currency risk. Outcomes have varied widely across past sovereign restructurings, but in the 1990s several Latin American countries renegotiated their debt, and in the case of Ecuador outright defaulted, resulting in their bond spreads widening to 700 to 900 basis points over the U.S. Treasury and Ecuador’s borrowing cost exceeded 45%. Nonetheless, the central lesson is clear: investors have alternatives, particularly when global savings are scarce, and governments that weaken creditor protections can face sharply higher funding costs.

The United States will also need to confront its deficit and debt issues. Gross federal debt exceeded $40 trillion in October, while annual net interest expense is now approximately $1 trillion—roughly 14% of projected 2026 federal outlays. TD Securities projects that interest costs will continue to rise to $1.5 trillion over the coming decade. The debt “snowball” is rolling down the hill and gaining both size and speed. Corporate borrowing this year of more than $445 billion, much of it related to AI infrastructure, adds another source of financing demand. SpaceX, for example, recently announced it is seeking approximately $40 billion to purchase Nvidia processors. At the same time, defined benefit pension demand for long-duration bonds may be changing. Strong equity markets and higher discount rates have improved funded status for many plans, allowing some sponsors to consider termination or reduce the urgency of adding long-duration assets. Open plans may also retain more growth exposure. For the bond market, the implication is that a historically less price-sensitive buyer may absorb fewer long-dated bonds. Issuers may therefore need to offer higher yields to attract a more rate-sensitive buyer base, placing upward pressure on the term premium.

We have previously framed the deficit debate as a question of revenue versus spending. Under CBO’s February 2026 baseline, federal revenue equals 17.5% of GDP, slightly above its 50-year average of 17.3%. Federal outlays equal 23.3% of GDP, compared with a 50-year average of 21.2%. Historical averages do not, by themselves, determine the appropriate size of government, but they clarify where the current imbalance resides. An intelligent public conversation about the sustainable size and scope of government might be both productive and refreshing. The composition of revenue has also shifted: individual income-tax and tariff receipts are elevated, while payroll and corporate-tax receipts are below longer-term norms. IRS data for 2023 show that the top quartile of taxpayers received 68.5% of adjusted gross income and paid 86.3% of federal individual income taxes, while the bottom half received 12.3% of AGI and paid 3.3% of those taxes. Broader measures that include payroll, corporate, and excise taxes show that the bottom 20% of earners have an effective tax rate of -10% while the top 20% of earners had a rate of 17%. The increasing concentration of the source of federal taxes received may identify disparities and risks that warrant awareness and discussion. The top 20% of earners accounted for 70% of tax receipts in 2022, up from 55% in 1979. With Social Security and Medicare facing mounting financing pressure over the next decade, policymakers will ultimately need to address both revenue generation and expense management.

The midterm elections may provide a source of recovery for the bond market. Not because this crop of politicians will compete in the arena of ideas and further the ideal of a shared successful future, but because gridlock remains the most likely outcome. It will probably reduce legislative productivity, but it could also limit the passage of large new spending programs and slow further deterioration in the deficit outlook. Bond investors may view that constraint favorably. A change in congressional control could also alter the administration’s latitude on Iran, although the direction and magnitude of that effect are uncertain. If military activity moderates and oil flows improve, inflation pressure could ease, giving the Fed more room to pause once policy is on the restrictive side of a neutral range. In that scenario, the bond market could recover into year-end. The path will not be linear: geopolitical decisions, supply shocks, and the Fed’s unusually limited forward guidance will continue to create volatility and an elevated information premium.

If that is the upside case, the downside case is defined by concentration and fragility. Last quarter, we cited the Bank for International Settlements on the risk that doubts about returns on AI investment could trigger a pullback in capital spending and financing. A form of concentration Warren Buffet historically watches are corporate profits as a share of the economy. In the second quarter of 2026, profits relative to nominal GDP hit an all-time high of 12.1%. This record profit metric was made possible due to the AI spending boom, fiscal stimulus in the form of a 6% budget deficit and consumers appear to be sustaining spending at the expense of decreased savings. That combination may not be sustainable. Goldman Sachs estimates that AI-related spending accounts for nearly half of expected earnings growth among S&P 500 companies. Near-term revenue is strong, but depreciation and operating costs may emerge with a lag. If confidence in the economics of the AI buildout weakens, a sharp decline in investment and credit availability could spill into employment, profits, and asset values. Household finances show a similar concentration. The Federal Reserve’s 2025 Survey of Consumer Finances found that median net worth for households headed by someone age 75 or older rose 37% from 2022 to 2025, while median net worth for households under age 35 fell 23%. Across all households, real mean net worth increased 7% to $1.24 million, while median net worth rose only 2% to approximately $216,000. That gap illustrates how asset appreciation has disproportionately benefited wealthier households. Labor-market conditions are mixed: unemployment is 4.2%, and job openings are approximately equal to the number of unemployed workers, yet unemployment among recent college graduates is materially higher than for college graduates overall. Consumers are saving less, younger households are under greater financial strain, and the economy is increasingly exposed to a narrow set of investment and asset-price drivers. That concentration could amplify the damage if AI capital spending or equity markets weaken.

Municipal Market Developments – Lemons and Lemonade

The quarter’s defining municipal-market development was the sharp rise in yields. The move did not reflect broad concern about issuer creditworthiness or a major change in tax policy. Municipal yields rose alongside Treasury yields, but heavy new issuance had to be absorbed by an investor base increasingly dominated by households and household-oriented vehicles. Lower corporate tax rates have reduced the relative appeal of municipal debt for banks and insurance companies, shifting more of the supply-demand burden to individual investors. Because those investors may be slower to deploy capital during periods of volatility, temporary imbalances can become more pronounced—and can also create attractive entry points.

September was among the weakest months for municipal bonds in nearly four decades, although a late-month rally kept it from finishing as the worst month since 1987. Municipal issuance totaled approximately $474 billion through September and remained on pace to exceed 2025’s record of $563 billion. The municipal market therefore contributed to the same crowding-out pressure affecting corporate and sovereign borrowers. At quarter-end, high-quality 10-year municipal yields were near 4.1%, while long-term yields exceeded 5%. For investors in high federal and state tax brackets, taxable-equivalent yields ranged from roughly 7% to nearly 10%, depending on state of residence and tax assumptions. Opportunities to purchase 5% coupon bonds near or below par have been rare over the past two decades, occurring during only six episodes. Importantly, the sell-off reflected interest-rate and supply-demand pressure rather than broad concern about municipal credit quality.

The quarter will be painful on investor statements, but it may also create two useful opportunities. First, many municipal investors now hold bonds at unrealized losses. After consulting a tax adviser, investors may be able to realize those losses, offset gains elsewhere, and reduce concentrated equity positions or make other portfolio changes with less immediate tax cost. Second, investors may be able to sell lower-coupon bonds, realize a loss, and reinvest in higher-coupon bonds, potentially improving portfolio income over time. The industry appears to be taking advantage of this opportunity: open-end municipal bond funds experienced substantial outflows, while municipal ETFs attracted inflows during the quarter. Despite the yield spike, market stress was less severe than in prior municipal-liquidity episodes. The growth of separately managed accounts may have helped because SMA portfolios are often managed with a buy-and-hold orientation and selling can be targeted to specific tax-loss or portfolio objectives rather than broad liquidation. Although yields have retreated from their recent peaks, continued issuance, competition for capital, and year-end tax-loss harvesting should create additional opportunities for investors averaging into the market. Fully invested municipal portfolios may recover some market value before year-end, but 2026 is still likely to produce flat to modestly negative total returns.

Strategy and Summary – What Just Happened?

Momentum remains on the side of the AI buildout, but the remainder of 2026 is likely to feature uncertain energy markets, heavy borrowing by participants in the AI race, and persistently elevated yields needed to absorb record debt issuance. Consumers face weak real wage growth, elevated debt-service burdens, declining saving rates, and increasing delinquency pressure. Concentrations in income, wealth, tax payments and presumably share of federal revenue feel like it is sowing the seeds for some form of future risk and perhaps social change. Whether it is the federal deficit, AI buildout, or savings funded consumption, the sources of growth in the U.S. seems to be on an unsustainable path. Near term, rates may stabilize if divided government limits additional fiscal expansion. A more pronounced bond-market recovery is possible if the Iran conflict de-escalates, oil prices decline, and the Fed can stop tightening near a neutral-to-modestly restrictive stance. With bond yields near multi-decade highs and real yields approaching a two standard deviation event, gradually adding long-duration exposure while retaining a complementary allocation to money-market or cash-plus strategies remains an attractive risk-adjusted approach.
 

Our earlier forecast that the 10-year Treasury yield would remain between 4.0% and 4.8% in 2026 needs revision. The yield reached approximately 5.3% during the quarter, and a further escalation in the Iran conflict could push it toward 5.75%. A broader slowdown in AI investment—triggered by doubts about project economics, tighter capital access, and spillovers into employment and corporate profitability—appears more likely to be a 2027 risk. For 2026, flat to negative bond returns remain the most probable outcome; 2027 should begin with a more attractive yield cushion. The municipal market dislocation may prove to have been an appealing entry point once the supply-demand imbalance normalizes. Iran will remain central to both inflation and the bond market outlook. The conflict’s range of outcomes remains unusually wide. For investors, the relevant conclusion that energy supply, fiscal policy, term premium and risk spreads will remain tightly linked.

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