Municipal Quarterly Insights 4th Quarter 2025

Q4 Review – The Fed Eases

The fourth quarter of 2025 brought more subdued trade-related headlines. The primary development was a reduction in certain “fentanyl” tariffs placed on China to 10%, down from 20%, alongside the elimination of China’s 10% to 15% tariffs on select U.S. agricultural goods. The remaining stories that played out over the final quarter of 2025 were the government shutdown, the “K-shaped” economy, generally softening job data, and stubborn inflation. “Affordability” was, and will continue to be, the rallying cry for political campaigns. With average home prices exceeding $400,000, and the average car price nearing $50,000 – both typically financed at rates of roughly 6.25% to 7.0% - the largest purchases for most people are increasingly out of reach. According to the National Association of Realtors’ 2025 Profile of Home Buyers, the median age of new home buyers is roughly 40, up from 30 in 2010. Edmonds reports that in Q4 2025, 20.3% of new cars financed have monthly payments of $1,000 per month or more. A natural response to high costs is to defer purchases. The U.S. auto fleet average life is approximately 12.8 years old, the oldest on record (Source: S&P Global). It seems that affordability and adaptation will be guiding themes for 2026.

Although the government shutdown grabbed a lot of headlines, the resolution ended up with the usual endgame; federal workers received backpay, fired workers were rehired, and SNAP benefits were extended through September 30, 2026. Covid-era ACA subsidies were left unaddressed, and the continuing resolution that funds the government is only through January 30, 2026 (so we will likely have another shutdown to discuss next quarter). It’s no wonder why the rating agencies see the cycle of debt ceiling threats followed by a game of political chicken, followed by a continuing resolution to be unbecoming of the world’s largest economy. In the end, the 43-day shutdown seemingly offered few political wins, likely imposed a small drag on the economy, and both the Fed and the markets had to navigate the economy with an information deficit.

In the face of general - but not uniformly - softening employment data and largely stubborn inflation numbers, with neither offering a clearly outsized influence over the other, the Fed continued their progression toward a neutral stance. In both October and December, the Fed lowered the target range of the Fed Funds Rate by 25 basis points (0.25%). October’s cut was more “run of the mill” but the December cut is where things got interesting. In the final meeting of the year the Federal Reserve took the target range to 3.5% - 3.75%, but there were three dissenting votes, two voting members didn’t want a cut and one member wanted a 50-basis point (0.50%) cut. Recently appointed by President Trump, Governor Stephen Miran wanted the steeper cut and since the meeting, he has said he believes the Fed Funds Rate should be 100 basis points (1.0%) lower to be appropriate for the economy. Although he is only one of twelve voting members, at the margin it feels like he will be a perpetual source of support for an accommodative stance. More interesting, the dispersion of votes represented the most divided the FOMC has been since 2019. It suggests, as Minneapolis Fed President Neel Kashkari indicated this week, that the current policy stance is near a neutral position and that the Fed may not need to cut rates much further. The calculus for future Fed action hinges on any emerging directional dominance between sluggish employment numbers and sticky inflation. Any number of looming “risk off” influences stand ready to tip the scale toward an easing stance and the likelihood of upward inflationary pressures seems more remote.

An additional surprise that arose from the December meeting was a faster than expected announcement that the Fed would initiate a targeted Quantitative Easing (QE) effort, by buying $40 billion a month of short-term Treasuries to get past some seasonal challenges in April and then eventually taper down to $25 billion per month. The program is intended to support banking system and market liquidity. Last quarter we touched on some small cracks in the liquidity environment as the Fed moved from a target of abundant reserves to a level that was deemed to be “ample,” which was prescient. The Fed’s surprise QE program reduces the risk of a credit crunch and related credit spread moves in the bond market. It should serve as a source of calm in an economy that may face several sources of challenge in 2026.

Over the course of the year, 10-year Treasury yields moved slightly lower from 4.57% to 4.16% and 10-year high quality municipal yields also fell from a yield of 3.12% to a yield of 2.72% as 2025 ended. Taxable bond indexes experienced annualized total returns of approximately 7.3% to 7.5% and municipal bond indexes experienced total returns of between 5% and 6%.

Q1 Interest Rate Outlook – The Risks Remain (Mostly) the Same

Last quarter we thought the upcoming Supreme Court decision on tariffs had the sway to make or break the quarter. Current thinking is that the decision will most likely be released in January or February, and the chance that the decision will be released at the end of the current session, in June, is remote. We continue to expect the decision may be a driver of U.S. markets, the trajectory of the economy, interest rates, Fed policy, the influence of the wealth effect on the K-shaped economy, and the broader “risk on” environment. It may also have meaningful implications for foreign and trade policy with “egg on face” that could exact a serious cost since a large part of the Trump agenda involves foreign investment in the U.S.

Our base case expectation continues to be that the “trafficking” tariffs on China, Canada, and Mexico will remain in place for some time, while flat tariffs are most vulnerable. Prediction markets are suggesting that the tariffs will be struck down. Against the backdrop of our persistent fiscal imbalances, tariff revenues seem to be the least painful avenue for narrowing the deficit. As mentioned in the past, revenue as a percentage of GDP is near long-term average levels while spending as a percentage of GDP is above average. It points to a “spending problem” over a “paying for” problem. Setting the fiscal blame game aside, tariffs are a broadly-based tax on consumption, where the negatives can be mitigated and the incremental revenue could delay our day of reckoning. The shock of entering a new period of trade policy uncertainty, along with renewed fears of runaway deficits, will likely cause “risk off” tremors. The de-dollarization theme will get new oxygen, long bond yields may increase, bond risk spreads could temporarily widen, only to recover when the stories about the revenue generated from the “trafficking” tariffs will mostly cover the cost of President Trump’s One Big Beautiful Bill Act. We would still be running an annual deficit of more than $1 trillion to $1.5 trillion, an improvement from nearly $2 trillion, though hardly a comfortable outcome. Absent some revenue generation or expense cutting, preferably both, the pain of the solution at a future date will be excruciating at a minimum and to say it may result in an economic regime change doesn’t give that outcome the weight it deserves.

Hypotheticals are a risky exercise (because you will almost always be wrong) but the impact the decision could have on the markets may be significant. Starting with the “bad day” scenario, which is that tariffs are struck down and previously collected funds will need to be returned. We would likely heavily revisit the de-dollarization theme, and the added gravity of the fiscal situation would probably see longer bond yields rise. It could trigger a “risk off” moment where bond spreads widen, stocks sell off due to corporate and individual belt tightening, and the employment environment moves from being sluggish to being sour. It could very well be the moment when the “credit cockroaches” – credit stresses that come out during periods of economic volatility - emerge. Recent JOLTS data show that the ratio of job openings to job seekers has fallen to 0.9X, the lowest since March of 2021. To date, we have been in a low hire, low fire employment environment. Corporate tightening, and recent AI productivity gains, could put jobs at risk. The economy hasn’t had recessionary bloodletting in a long time, and we anticipate that corporations would make unpopular decisions in a period of economic turmoil.

Absent tariff revenues, our nearly $2 trillion deficit would become very real and changes would be required. The first move might be the Fed cutting rates to protect the job environment. The same move could be the other side of the “fiscal dominance” coin, where the central bank lowers short rates to make the cost of financing the debt and deficits more manageable on a temporary basis. Rate cuts would provide relief across many cohorts. It may help consumers with the cost of revolving debt. It could support the banking system by not furthering the challenge many banks have with “underwater” securities. Perhaps most of all, it would reduce the cost to finance the federal debt. A less obvious - but plausible - outcome could be bipartisan negotiations toward a grand bargain. It is possible that in exchange for making tariffs more permanent, a legislative solution exists where Democrats can get the ACA subsidies they are seeking in exchange for the votes needed to get related legislation through both Houses of Congress. As of the time of the writing of this piece, a three-year extension of the subsidies passed the House, but it has yet to make it through the Senate. It is estimated that ACA subsidies would cost $350 billion over 10 years, and if you limit the subsidies to people with incomes of 300% of the poverty line and below, the cost would be $175 billion. In late 2025, tariff revenues were clipping along at $30 billion a month, which translates to an estimated revenue over 10 years of $3.6 trillion. The CBO estimates that the One Big Beautiful Bill Act (OBBBA) will cost $3.4 trillion over 10 years. In exchange for tariff legislation, Democrats can have most of their ACA subsidies, and President Trump’s OBBBA would be roughly deficit neutral. To be clear that does not mean we wouldn’t have deficits, they would still be an unacceptable $1.5 trillion, but the two “wants” of the political parties would be paid for (this ignores possible increase in borrowing costs or above trend economic growth). Just as probable, partisan politics as they could result in a scenario where we “crash the car” through a shutdown stalemate, patchwork of tariff revenue workarounds which will be challenged in the courts, runaway deficits, and a reversal of the prospects of foreign investment in the United States. That’s pretty much a bad day for everyone. It could precipitate the dreaded “doom loop” mentioned last quarter, where a government is forced to borrow more money at ever higher yields to pay interest, which can result in a compounding cycle.

We’ll try to offer a brief “good day” scenario. Tariffs are upheld and President Trump may still work with Congress to codify the tariffs, offering some ACA subsidies as an olive branch to show that some bipartisan efforts can succeed in the face of party extremes. The new trade regime is established, and all actors can proceed with knowledge of the rules of the game. Resulting foreign investment supports U.S. economic growth and jobs. We enjoy a stable bond market and both corporate earnings and stocks advance. Lower- and middle-class workers experience real wage growth and tariff impact can be mitigated for this group though tariff dividends. It is clearly a sunshine, rainbows, and unicorns scenario, but it is possible. Admittedly, some of this scenario may come from a belief that the K-shaped recovery is challenging for the health of the country. The top 10% of earners account for 49% of consumption. We have a record number of jobholders with multiple jobs. It suggests to us that the quality of many jobs is not what they were in the past. Credit card and subprime auto loan delinquency rates are the highest they have been in 14 years and 31 years, respectively. We’ve already touched on the affordability of housing and cars. We’ll either regain our shared brand, or we may risk a long-term fracture. The “good day” scenario is worthy of hope.

In our base case scenario, unfortunately not much changes from the past year. Uncertainty will persist as President Trump attempts other approaches to replicating the flat tariffs. It doesn’t lend itself to foreign investors and companies jumping into the U.S. with both feet, as they may wait for a more certain set of rules, especially with the likelihood of divided government in January of 2027. Politics will be as they have been (toxic). Independent of trade and tariff benefits, some aspects of the OBBBA should be stimulative in 2026. Specifically, the no tax on tips and overtime, increased SALT deduction caps, larger tax refunds, and business depreciation acceleration aspects of the bill are expected to deliver $285 billion in fiscal stimulus in 2026. Assuming the AI infrastructure build out investments remain static or grow, the stimulative influence of the OBBBA in 2026 could add 1.2% to annual GDP growth. AI will bring productivity advancement, but it may come at a cost for traditionally upwardly mobile college graduates. Entry level positions in corporate roles are down 15% year over year, and job description references to AI are up 400% over the past two years. It bodes well for the likelihood of continued corporate profit growth, but it may cause similar career ladder challenges as the Millennials experienced during the Great Financial Crisis.

On the shoulders of Q3 2025 GDP of a robust 4.3%, a Federal Reserve that is newly supportive of market liquidity and lower rates, and the fiscal stimulus of the OBBBA, there is a case to be made that some of the best developments of 2025 will continue in 2026. We have our eye on a few “black swan” risks to the economy and the current “risk on” environment. We’ve spoken at length about the Supreme Court decision, so suffice it to say that the magnitude of the decision offers several unexpected and nuanced outcomes. Investors will simply have to adapt to the evolving reality. AI feels like an unstoppable freight train of capital expenditure and economic activity. We suggest investors be aware of the copyright infringement case between the New York Times and OpenAI. Using copyrighted material to train models or as compensated research output should result in compensation for the content originator (if properly protected). The case runs the risk of putting the brakes on some of the economics of AI in the U.S. and at the extreme, it could create temporary progress paralysis for AI development. In a race where the finish line is artificial superintelligence and the result could be a “winner take all” contest, a pause in progress could hand China a significant advantage. The case could introduce significant doubt about the economics and competitiveness of U.S. AI offerings. Another iceberg beneath the surface could be the Manhattan office of the DOJ looking into how private credit and private equity firms are valuing assets in their portfolios. Recently, some large private credit loans have gone from being valued at a dollar price of $100 in one month and $0 the next month. The market danger and conflict of interest that could be caused by managers determining the value of their assets, on which they charge a management fee, are obvious. Although the Trump administration is generally expected to have a “hands off” regulatory approach, this is an area that could cause market volatility and disruption if valuations are allowed to persist at fantasy levels, especially if there is an economic slowdown. A washout of private credit loan values would likely bleed into the junk bond market, and it very well could influence credit spreads more broadly which are currently uncomfortably tight. All three “black swan” events offer the ability to be an impetus to derail the “risk on” environment.

Municipal Market Developments – Potentially More of the Same

As compared to last quarter, there isn’t much to report in the muni market, so we will focus on the supply and demand influences and how we think the asset class should perform in 2026. We start from a similar place to where we were a year ago. Municipal bond yields as compared to Treasury yields are below average, except for the very long end of the yield curve. At the same time, current yields are above where they have been for large swaths of the past decade, but below longer-term experience. Last year we mentioned that forward returns are often influenced by the yield of a bond at purchase (stated another way book yield and related coupon income of a “current” coupon bond heavily influence total return over the life of a bond). Given where current coupon bonds currently sit and our outlook for short rates to fall while longer term yields are largely stagnant, our estimate is that municipal bond indexes will earn “coupon-like” returns in 2026 (roughly 3%). We would add some performance for roll return (the price support bonds often gain as time shortens the number of years to maturity of a bond), but our starting relative value position mentioned earlier may negate other sources of return over the course of the year.

We will ignore seasonal and temporary municipal market supply and demand dynamics and focus on elements we expect will drive the major municipal market action in 2026. Supply of new tax-exempt issues in 2025 was a record level of issuance, approaching $570 billion. Due to elevated building costs, and other borrowing needs emerging in the market, estimates are that roughly $600 billion will be issued in 2026. Supply will likely continue to be above average, which in isolation would suggest elevated yields as compared to Treasury yields. Using our base case economic, risk appetite, and yield forecast mentioned earlier, demand for munis may remain strong. Questions arise from the recent exposure of alleged fraud that could plague many states, but we see it as a good development if these costs are brought out into the light of day. The expansion of separately managed account (SMA) municipal bond portfolio management offerings has emerged as a preferable method of exposure to this asset class. To the extent the assets are not simply cannibalizing exposure from mutual funds, often with higher management fees, this has been a source of demand strength for municipal bonds. Technology has allowed for sources of utility and customization that ETFs and mutual funds can’t offer, and the account minimums are now making the advantages of SMAs available to more investors. We expect that demand for the municipal asset class will remain robust. The status quo state of the muni market should be further supported by the likelihood of the periodic conversation about eliminating the tax-exemption of municipal bonds being pushed out through the end of the Trump Presidency.

As discussed last quarter, the turbulence in the muni market may come from one of the bedrock sectors, school districts. Hospitals, nursing homes, oddball semi-commercial issuers, and most things “Chicago” may earn headline space in 2026, but school districts face challenges for the next several years. That is not to say school districts are bad credit exposures, most are well-run and provide an essential function that will be supported by the populace. In our recent annual credit review of hundreds of municipal exposures, most school districts saw strengthening credit characteristics. The only negative theme we observed was a deterioration in the funded status of their pension obligations (and rarely is that a function of anything determined at the school district level). Our job is to watch for early warning signs and avoid exposures that start to experience rapid enrollment losses, disproportionate debt loads, or worst of all, chronic cashflow borrowing (especially for operating expenses). In 2025, overall municipal market debt issuance grew by 15% while school system borrowing grew by 42% according to data compiled by Bloomberg. At $82 billion, it was the most issuance by schools since 2013. At a high level, the financial strains come from declining enrollment, inflationary pressures keeping expenses high, and changes in government funding. In late 2025, Moody’s released an excellent research piece that offered a deep dive into the challenges facing schools. On the revenue side of things schools are impacted by the subsiding of Covid-era stimulus dollars and declining enrollments. Many districts receive revenue based on headcount and whether it is dropping due to competition from education alternatives or a lull in the school aged population, headcounts are declining in many areas. The trend is not the friend for schools as the school age population is expected to decline by 5% from 2022 through 2031 as projected by the National Center for Education Statistics. At the same time as revenue is under pressure, expenses are on the rise. Compensation costs and tailored instruction expenses are at the heart of the challenge. For the third consecutive year, state and local education worker costs have outpaced those of the private sector. In 2025, education compensation exceeded the private sector by 0.6 percentage points. One of the fastest growing costs for districts involves special education services. As of 2023 the percentage of the students served under the Individuals with Disabilities Education Act (IDEA) has risen to 15%. Complying with the IDEA and addressing issues of Covid learning loss (involving counselors, interventionists, and other specialists) has grown this staffing need to nearly 367,000 in 2025. For perspective, that is more than 11% of the total population of teachers. Through the lens of a creditor, schools have a challenging operating environment for years ahead. From the perspective of an ACG client, it is important that we allocate a lot of effort and resources to intelligently navigate this environment.

Strategy and Summary – Many Paths, Few are Straight
 

The most recent Fed “Dot Plot” indicates they expect to drop the Fed Funds Rate by 25 basis points (0.25%) in 2026. The market is expecting something closer to 50 basis points (0.50%). Using our base case scenario laid out earlier, along with the backdrop of softening employment data, sticky inflation, and OBBBA stimulus we think two cuts or more will be needed to support the employment environment. The result of persistent deficits should be static to higher long-term bond yields. We expect that the 10-year Treasury yield will end the year close to 4%, which isn’t too far from where we started the year. The combination of falling short yields and stationary long yields will be a continuation of the bull steepener call we made for last year. In our base case scenario credit spreads may have room to widen in response to emerging credit cockroaches and simple mean reversion, which could modestly hurt fixed income returns. In response, we have a preference to buy “quality” in the form of Treasuries, highly rated issuers, and the least volatile sectors.

Many markets are priced for perfection, and rarely are we offered a year without bumps in the road. We’ve mentioned a few “black swan” events that individually could derail the current “risk on” environment. 2025 was expected to offer breathless “end of the world” developments, when in practice people and corporations simply adapted to the evolving situation. As the saying goes, “The end of the world as we know it is not the end of the world.” 2026 will most certainly give investors the opportunity to adapt - and evolve.