Tricky Times Ahead for Governments' Cash Managers

Oct. 28—After resisting presidential pressure to cut interest rates until it became clear that the inflationary impact of tariffs would not be as severe as first expected, the Federal Reserve has begun what appears to be at least a short series of likely quarter-point reductions in its key federal funds rate.

Just how many of those cuts there will be and how deep they will go in early 2026 and beyond is still the big question in the money markets. Except for a few government treasurers and their external cash managers who've already locked up higher-yielding investments maturing late next year and into 2027, budget officers are now questioning whether their 2026 interest income projections will hold up.

Welcome to the next "new normal." Shorter-term rates are declining, but not so much for longer maturities. Although many keep expecting this trend toward easier money to quickly result in lower mortgage interest rates to help the housing market, that's not so obviously in the cards for now. The same is true for municipal bond issuers: Longer-term muni yields have held pretty steady despite Washington's spin about stable inflation and benign tariff impacts. Wary bond investors still expect a healthy premium for the risks of future inflation and ballooning federal deficits.

Right now, there's still a slightly higher rate on the very shortest paper, but that will dissolve quickly if the Fed cuts rates again in coming months, as the futures market traders expect. For public agencies worried that their operating cash investment income may fall short next year, time is running out on their ability to lock up higher rates in case inflation dissipates or the economy softens.

Of course, there's no guarantee that further rate cuts will be delivered by the Fed, even though the bluster from the White House would suggest that more are almost inevitable. With a new Fed chairman about to be appointed and several regional Fed governors up for replacement, there is general marketwide concern that the White House will begin packing the central bank with easy-money leadership. Their implicit assignment would be to drive short rates lower yet in hopes of stimulating both the business sector and consumer spending — while magically reducing debt service costs for the U.S. Treasury. About the only things that could thwart that bias would be either a run on the U.S. dollar for various macroeconomic reasons or a belated flare-up of tariff-induced inflation.

The clear winners in state and local finance so far are the cash managers who locked up 2026 interest rates earlier this year. It's now impossible to match the yields they secured by extending maturities into next year, as most money market interest rates have already drifted lower. That makes heroes out of many of the private-sector external cash managers who use a longer-term benchmark for their portfolios: They typically now show juicier yields and capital gains.

Investment income revenue forecasts will be notably tricky for budget officers operating on July 1 or Oct. 1 fiscal years, especially if their treasurers or cash managers stayed liquid or ultra-short in order to enjoy what have now become transitory rates. Those with calendar-year budgets will likely come out OK this year, but they won't be able to match the income from their cash portfolios from this year into next.

Scrounging for Yield

So 2026 looks to become the kind of year when restless in-house cash managers start scrounging for ways to pick up some additional yield with funkier paper. For smaller governments, there may be opportunities to buy illiquid insured or collateralized bank CDs either directly from local depositories or through the various deposit brokerage networks. Managers with longer portfolios will be more susceptible to government bond peddlers pushing callable or step-up notes that offer attractively higher coupons — but with the risk that the holder won't be able to enjoy the juicier yields if the issuer calls them back before maturity. Cynics call that a sucker's bet against the house: Heads they win, tails you lose.

Meanwhile the interest rate situation in the tax-exempt municipal bond market has remained remarkably stable and seems unlikely to change that much going into 2026. For now at least, there seems to be no strong incentive to sell tax-exempt paper either sooner or later. Rates on shorter maturities have drifted down about a quarter-point this year, but have inched upward almost that much on the longer 30-year maturities. Unless we see an unexpected drop in inflation rates or the labor market weakens dramatically enough to start a recession scare, today's tax-exempt yields will likely continue to hover in their current range.

One thing will change in the muni market: reinvestment arbitrage. That's where tax-exempt borrowers can turn around and reinvest their yet-unused bonds' proceeds in taxable securities at higher yields. It's particularly relevant for short-term borrowings like tax anticipation notes, but also for construction financing — at least when taxable short-term Treasuries have rates that exceed tax-exempt muni yields. That gambit is likely to evaporate in early 2026 for most issuers of munis maturing in more than 13 months (the IRS arbitrage safe harbor).

A different kind of arbitrage opportunity for local government cash managers that could reappear in early 2026 will be the special case of a few state and county investment pools that typically invest in maturities longer than 200 days on average. In California, some pool managers have locked in various 4 percent yields that they will benevolently share with local agencies that can now jump out of money market instruments and into their pools as short rates decline. This practice would not be legally allowed for a commercial mutual fund, but it's kosher for an intergovernmental operation exempt from Securities and Exchange Commission rules.

The California state treasurer's local-agency pool is well known for this standing practice and, along with a few county treasurers, was chastised in this space three years ago when they stubbornly plowed into longer maturities in the face of escalating inflation and rising short rates. Now the Californians can enjoy some belated kudos for sticking to their "broken clock" strategy that is once again making money for their local governments (albeit at the expense of the state's general and special purpose funds). Soon they'll be heroes for persistently investing in maturities longer than a money market mutual fund.

No Heroes

Right now, markets seem to have fairly discounted the various possible scenarios for future rates moving in any one direction, so the yields on various maturities seem appropriately priced to reflect the risks of prices going too far in either direction. At this point, nobody is likely to become a hero from trying to outwit the big-money investors who deploy billions of dollars in the U.S. government and municipal securities markets.

My only caveat at this time is that federal deficits have not evaporated — even with easier money and tariff revenue — and this year the gold and cryptocurrency markets are signaling a "debasement" disbelief in currencies around the world. That should make purchasers leery of buying bonds with maturities beyond 2029 but still leave issuers inclined to sell callable muni bonds for infrastructure projects while the market is stable. Callable muni bonds are still the cheapest deal for sellers in public finance.

Next year's new-normal yield curve could prove to be boring for public treasury managers. In a world of political contortions and crossfire, governmental disruptions and economic crosscurrents, that would be a welcome respite for many.

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Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.

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