Central bank forward guidance continues to befuddle investors, with both the European Central Bank (ECB) in July and the Bank of England (BOE) in August raising rates more than expected. Fortunately, our EUR and GBP funds were both positioned well for the hikes and we saw fund yields increase almost immediately. As for future policy hikes, the ECB emphasized a “meeting-by-meeting” approach in its announcement. The BOE painted a somewhat darker picture of the UK economy, warning that recession is imminent and could last as many as five quarters – ouch! And still the BOE plans to raise rates. At the time of this writing it appears that market expectations are skewed towards larger hikes at upcoming meetings, in line with what we have already seen from the central banks. Futures show the ECB policy rate over 1% by the December meeting and the BOE policy rate over 3% by February ‘231.The outsized hikes make sense given global inflation outlook, but long end Sovereign rates are telling another story – at the time of this writing (August 11th) we have German 10y at 0.96%, France 10y at 1.53% and UK 10y at 2.05%2 - all pricing in the risk of a hard economic landing.
The Fed raised rates by 75bps in July as expected but Chair Powell was clear there would be an end to forward guidance. As of August 11th, the Fed Funds Futures curve is pricing-in additional rate hikes with a terminal rate at 3.64% in Q1’233. Additionally, futures are telling us the Federal Open Market Committee (FOMC) will start easing policy as soon as Q2’23; however, according to several Fed officials, that expectation is premature. Mary Daly (SF) noted the FOMC expects to leave policy rates elevated for some time, relying on jobs and inflation data to assess the appropriateness of a policy ease.
I have asked many market experts what “the end of forward guidance” means and have gotten a variety of answers, however one thing seems certain: the FOMC will no longer provide their policy rate expectations. I wonder if this means an end to the Dot Plot? We will have to listen closely to the regional Fed presidents, those not on the FOMC, to guide us in their thinking, as many continue to do. As a treasure or cash manager one need not worry as the Fed’s forward guidance has not been a great forecasting tool.
With all this central bank volatility in mind, we have taken an even more conservative approach on duration in the money market funds (MMF). The MMF industry has taken a similar approach. For the 10-fund composite I monitor, average Weighted Average Maturity (WAM) on a Govt fund is 18 days while a Prime fund averages 15 days. ICI's Month-End Portfolio Holdings show funds are reducing their exposure to US Treasuries and increasing their exposure to Repurchase Agreements (repo). According to this report repo remained the largest composition segment in June, increasing $153.4 billion, or 53.7% of holdings. Repo holdings have increased $792.7 billion, or 49.9%, over the past year. As our senior portfolio manager, Todd Bean, recently said at the Crane MMF Conference, “there is no shame in repo.” The Fed’s Reverse Repo Program (RRP)4 activity reflects an increased demand from the wider market. The Federal reserve reports as of August 11th that the RRP balances have been over $2 trillion since June 3rd. Certain market experts believe these balances could climb as high as $3 trillion before year end. JPM reports that approximately 91% of the RRP take up is Money Market Funds. Even Prime funds are in the game, growing their balances to over $250bln (+28% in July) according to the ICI holdings summary. US Treasury security holdings have subsequently decreased by 34% over the past year, highlighting how rich those yields have been vs. the Fed’s RRP repo rate. Government Agency paper, like Federal Home Loan Bank, looks similar in value to US Treasury yields, decreasing by 26% over the past year.
As we move through this very aggressive hiking cycle, the challenge banks will face is holding onto their deposits. Money market yields are now well over 2% and could surpass 3% by Q4. Only one brokerage sweep product (non MMF) was paying more than 1% for balances over $5 million as of July 29th. The average was 0.38% as of July 29th with some paying as little as 0.10%. Perhaps this is also why Retail Prime Money Market Funds are up by $54 billion since their low in May according to ICI as of Aug 3rd. Crane reports bank deposit account rates are averaging 0.94% as of July 29th, though only 2 of the 46 banks on their list are paying >2%. Meanwhile, major banks (BofA, Chase, PNC, USB, Wells) are paying just 0.01%.5 If banks continue to hold the yields on deposits significantly below the yield on a Money Market Fund we could see a faster move out of deposit accounts. This is not dissimilar to any other rate hike environment in the past (’04-’06 & ’15-’18) as banks tend to lag market rates. The challenge this time around is the speed of these rate hikes. Money Market funds were paying 0.03% only five months ago!6 It’s time to call your banker, find out what you are earning on your deposits and perhaps do some yield analysis on all your cash investments. Let us know if we can help.
1 Bloomberg, as of August 18th
2 Bloomberg, as of August 18th
3 Bloomberg, as of August 11th
4 The Fed’s Reverse Repo Facility (RRP) is a program where certain approved counterparties, including specific Money Market Funds, can lend US$ cash to the Federal Reserve’s NY Branch and receive US Treasury Bonds, Notes and Bills as collateral. The loans mature in one day and the rate is set by The Federal Reserve.
5 Crane data as of Aug 11th
6 Crane Data as of March 2022