Portfolio Strategist William Goldthwait sits down with April Borawski, Portfolio Manager, to discuss the latest trends in money markets.
Question: April, it’s been a while since we have checked in with you on money markets. What has been going on over the past month or so?
Several of the themes we discussed in the past still hold true today, such as uncertainty on how aggressive the Fed will be on its monetary policy path. That, coupled with rich market levels on both the fixed and floating side has made it a challenging environment as an investor!
Question: What is the cash management team most focused on in the current market environment?
We have already had 225bps of rate hikes this year and it’s possible we get another 75 in about a week. In the US, the labor market remains very tight and the unemployment rate is hovering in the mid 3% range, levels not seen since the 1960s. Inflation remains elevated: Core PCE, the Fed’s preferred measure of inflation, has averaged +4.9% YoY since the beginning of the year, levels that haven’t been seen since the 1980’s. Taken together, these conditions explain why the Fed has been so aggressive on raising rates.
Question: What has that meant for our cash strategies?
April: We began to adjust our thinking, and therefore strategic positioning, as early as last fall. We chose to sit short, heavily invested in overnight repo and the Fed’s RRP, instead of locking money up further out the curve at rates that could, and frequently did, underperform versus short dated repo/the RRP. We felt the Fed was behind on raising rates and as time passed, the Fed clearly acknowledged that. Ultimately the Fed needed to tighten faster and sooner than many of our peers expected, resulting in an outperformance in our strategies versus our peers.
Question: There has been a lot of talk about the Fed’s “pivot”, or when they might stop hiking and potentially ease policy rates, similar to what happened in 2018-2019. Does the team have any thoughts on a potential change in Fed rhetoric?
As we continue along the Fed’s hiking cycle, the timing of when funds choose to extend duration will be critical – especially as we move towards an environment in which the Fed might need to pause or even cut rates. But, are we there yet? All signs point to no, we aren’t there yet. The economy has proven to be robust enough to withstand aggressive policy moves for the foreseeable future, and we believe the Fed will make good on their promise to keep rates higher for longer in order to quell price pressures.
Question: What about forward guidance? Now that it is gone, what does that mean?
It was unclear what Powell meant when he said the end of “clear guidance”. There is always room for debate around how the various Fed officials’ words translate into rate hikes or cuts. At the time of this writing the market is back to pricing a 75bps September hike. Although before the recent WSJ article confirmed the FOMC wants a 75bps hike the market had been back and forth depending on what data and Fed rhetoric has hit the tape each day. Regardless, both Fed officials and the market are pointing to higher rates. Fed Funds Futures are pricing a policy rate that is close to 4% by the first quarter of next year. Chairman Powell also expressed the Fed’s comfort in continuing to tighten at the Jackson Hole Symposium stating, ‘…In current circumstances, with inflation running far above 2 percent and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause.”
Question: So the Fed keeps hiking?
Yes. What remains unclear is the size and timing of additional rate hikes, making the decision of when to extend money market funds difficult. As I noted above, we will want to extend at some point, but currently most term investments offer little-to-no upside versus sitting in the Fed’s RRP. Our shorter positioning has made our strategies a comfortable place to be.
The time to extend is likely not upon us yet given current Fed and market expectations/pricing. Although, the window in which money market funds may have to extend could prove short, as the market might interpret any slowing in the Fed’s hiking cycle as a harbinger of imminent rate cuts, i.e. the curve would invert, making extension less attractive. Therefore, funds must be willing and ready to add duration should market levels move closer to break-evens.
Question: There has been a lot of discussion about T-Bill yields and how rich they are. What should we expect over the next few months?
Over recent weeks Treasury Bill supply has increased by ~$210bn, a welcome shift for short-end investors. The increase in supply has helped nudge bill yields higher and closer to break-evens; although, the demand for bills continues to outpace supply. One clear indicator of the supply/demand imbalance is the roughly $2.1 trillion of demand for the Fed’s RRP. Similar to T-bills, government agency discount note issuance has increased, pushing yields slightly higher. Although most of these agency discount notes offer a yield advantage versus their T-bill counterparts, their levels are still rich to break-even of rolling overnight repo. Thus we have limited interest. This trend is likely to persist in coming months.
Question: What about floating rate notes? How do they add value to the strategies?
Through a typical market cycle, floating rate notes will add value in a cash strategy. The frequent reset and longer maturity allow you to capture term premium without the interest rate duration. At present we do not see a lot of value in adding meaningfully to our floating rate note positions, although we do add selectively to TFRNs (Treasury Floating Rate Notes). These positions have fared well given the continued steepness of the bill curve.
Secured Overnight Financing Rate (SOFR) floaters remain just fine. What I mean by fine, is that given their one day interest rate duration and positive spread they should not underperform RRP, but they also do not help you meaningfully, as you would have to add a large position in order to add incremental yield to the strategy.
Question: So can you sum it up for us?
We are still being paid to be cautious and respect an aggressive Fed. We continue to lean heavily on the Fed’s RRP. We have added select positions in term maturities to hedge a little. Nonetheless, even with these term positions, we remain well positioned to move into additional and potentially aggressive rate hikes.