Municipal Bonds and Monetary Policy: Evidence from the Fed Funds Futures Market

• Published date: 01 May 2014
• DOI: http://doi.org/10.1002/fut.21606
• Author: Carlo Rosa
• Date: 01 May 2014

MUNICIPAL BONDS AND MONETARY POLICY:

EVIDENCE FROM THE FED FUNDS

FUTURES MARKET

CARLO ROSA*

This paper examines the impact of conventional and unconventional monetary policy on

municipal bonds using a novel high‐frequency dataset. I use three proxies for monetary policy

surprises: the surprise change to the current federal funds target rate, the surprise component

in the Federal Open Market Committee (FOMC) balance‐of‐risk statement, and the unan-

ticipated announcements of future large‐scale asset purchases. Estimation results show that

monetary policy news have economically important and highly significant effects on municipal

bond prices. Their daily responses are, however, substantially lower than the reaction of

comparable Treasury notes. This work documents that market (in)efficiency, and the slow

adjustment of municipal bond prices, can partially rationalize this discrepancy. © 2013 Wiley

Periodicals, Inc. Jrl Fut Mark 34:434–450, 2014

1. INTRODUCTION

Many studies have examined the impact of monetary policy on asset prices (see, inter alia,

Kuttner, 2001; Rigobon& Sack, 2004; Bernanke & Kuttner, 2005; and the references therein).

This relationship is an importanttopic for several reasons. From a central banking perspective,

this line of research shedslight on the monetary policy transmission mechanism. In particular,

movements in asset pricesaffect consumption and investment via wealtheffects and effects on

the value of collateral. Market participants are likely to be equally interested in this topic

since monetary policy decisions are often associated with large asset price movements. It is

therefore importantfor retail and institutional investors to understand the link between Federal

Reserve policy and asset prices in formulating effective trading and hedging strategies, and

portfolio allocation decisions. As stated above, while the impact of monetary policy on broad

asset prices has been well documented, relatively little is knownabout the effect on municipal

bonds specifically. This paper fills this gap by using a novel high‐frequency dataset.

U.S. states and local governments are direct providers of valued public services,

including schools, streets and highways, hospitals, housing, utilities (water, sewer, electricity,

and gas), and power utilities, and public safety. These investments and services are a major

Carlo Rosa is an Economist in the Markets Group at the Federal Reserve Bank of New York. I thank George

Dotsis, Nancy Duong, Tony Rodrigues, and Giovanni Verga for useful comments and I also thank an

anonymous referee for detailed comments on an earlier draft of the paper that led to significant improvements.

All remaining errors are mine. The views expressed in this paper are those of the author and do notnecessarily

reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.

*Correspondence author, Markets Group, Federal Reserve Bank of New York, 33 Liberty Street, New York,

NY 10045. Tel: 212‐720‐5899, Fax: 212‐720‐1794, e‐mail: carlo.rosa@ny.frb.org, website: http://nyfedeconomists.

org/rosa

Received September 2012; Accepted January 2013

The Journal of Futures Markets, Vol. 34, No. 5, 434–450 (2014)

© 2013 Wiley Periodicals, Inc.

Published online 15 February 2013 in Wiley Online Library (wileyonlinelibrary.com).

DOI: 10.1002/fut.21606

component of the U.S. economic activity, both in terms of employment (19 million jobs; one in

seven total nonfarm), and as a contribution to the overall economy (roughly 10% of GDP). The

municipal bond market is the primary credit market for state and local government, and

municipal bonds (also known as munis) are an important financial instrument to smooth

irregular revenue flows in the short‐term, and to finance large infrastructure projects in the

longer‐term. Its size has currently grown to roughly $3.7 trillion in long‐term debt

outstanding, up from $1.5 trillion in 2000, making it one of the largest asset classes in the

United States. Households directly own about a third of outstanding municipal securities,

whereas money market and open‐end funds hold another 27%. The main advantage of

traditional municipal securities compared to corporate bonds is that their interest income is

usually exempted from the federal income tax. Furthermore, most states do not levy income

taxes on residents for interest earned on their own bonds. As noted by Bernanke (2007),

“monetary policy works in the first instance by affecting financial conditions, including the

levels of interest rates and asset prices.”Changes in financial conditions in turn influence

consumption and investment decisions by households, firms, and the public sector. Hence,

from a central bank standpoint, it is important to understand the link between monetary policy

decisions and statements and municipal bond yields, and to what extent changes in the

overnight rate pass through to other borrowing costs.

The main findings of the paper can be summarized as follows. First, monetary policy

news have highly significant effects on municipal bond prices. The daily responses of bond

prices are, however, substantially lower than the reaction of comparable Treasury notes. On

average, a hypothetical 100‐basis‐point surprise cut in the federal funds target rate is

associated with roughly 50‐basis‐point decrease in the five‐year Treasury rate, but only 8‐

basis‐point decrease in the five‐year AAA‐rated municipal bond. An unanticipated hawkish

balance‐of‐risk statement, when market participants expect a neutral statement, is associated

with 7‐basis‐point increase in five‐year Treasury rates compared to only 3‐basis‐point increase

for five‐year AAA‐rated rates. The systematic lower response of municipal bond rates

compared to Treasury rates holds not only for monetary news but more generally for a broader

set of macroeconomic news announcements. This work documents that market (in)efficiency,

and the slow adjustment of municipal bond prices, can partially rationalize this discrepancy.

Second, this paper shows that statements have a much greater explanatory power of the

reaction of municipal bond yields compared to monetary decisions. This finding indicates that

similar to what happens with other asset prices municipal bond yields are strongly influenced

by the expected path of policy. Finally, this paper documents that unconventional monetary

policy significantly affects long‐term municipal bond rates. Hence, there are significant spill‐

over effects from the Treasury market to long‐term municipal bonds, which might arise from

the sellers of securities to the central bank using their new money balances to bid up the prices

of other assets. An important policy implication of this finding is that the Federal Reserve may

still be able to ease monetary conditions, and drive down other interest rates, by targeting

purchases of only Treasuries.

By lookingat the asset pricereactions to the FederalReserve’s monetary policy,this paper is

related to differentstrands of the literature.A number of studies investigatethe influence of the

Federal Reserve’s unanticipated policy rate decisions on U.S. asset prices.

1

This strand of

research has reached a consensus that U.S. asset prices respond strongly to unanticipated fed

funds target rate decisions.

1

Some important studies include Kuttner (2001) for Treasury rates, Beechey and Wright (2009) for Treasury Inflation

Protected Securities rates, Bernanke and Kuttner (2005) and Wongswan (2006) for stock prices, Fatum and

Scholnick (2008) for exchange rates, Vahamaa and Aijo (2011) for implied volatility, and Zhu (2013) for credit

spreads.

Municipal Bonds and Monetary Policy 435