Municipal Bonds – Underlying Weakness

I want to call attention to the shakiness in municipal bond markets. Cities are having trouble meeting budgets due to unanticipated revenue losses while having to expand essential services – overtime pay for police, fire, and medical workers. Higher costs and less revenue mean wider budget gaps. Even with laying off other workers – which itself puts a burden on state unemployment systems, more on those later – city governments have to borrow money to stay operational.

Enter the current financial crash. Cities have to spike up their yields in order to meet investor demands for return on risk. Interest rates are moving into “expected default” territory for municipalities, where investors hope to recoup their invested capital and a small return through high interest rates before the borrower defaults.

Mutual funds have already dropped over $10 billion in muni bond investments, and that continues to increase.

The Fed can intervene to buy short-term muni bonds, but cannot buy long-term bonds. It would need legislation passed in Congress and signed by the President to get that ability.

But the Fed may have to also move soon to aid the states. Recall my reference to unemployment. States are looking to lay off employees in order to have enough money to pay unemployment claims… and there is also the issue with unemployment insurance funds’ solvency. 22 states are below Department of Labor recommended funding levels – and big states like New York, California, Texas, Illinois, Ohio, Massachusetts, and Pennsylvania are all below that recommended minimum. TX, NY, and CA are the three lowest in their ratios.

With 3.3 million unemployed last week and another big number expected this week, even properly solvent funds will be strained. The Fed will have to step in to provide liquidity for states to meet those unemployment insurance demands, as those are not discretionary spending items.

As I mentioned before, getting out of a financial crisis requires increasing national debt by a very large amount. The $2 trillion package is only the start – expect about $15-21 trillion more. And then the question to follow on to that is this – will the Fed get enough solvency itself to cover the state budgets? If not, I’d expect high inflation as a means of balancing the books. Would that be fair? Of course not. Would it be necessary to prevent a national bankruptcy? That’s very much a possibility.

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