To provide greater insight into the current state of money markets as well as the outlook for 2023, we conducted the following Q&A session with Jeff Plotnik, Senior Managing Director of Funds Management. Jeff is instrumental in setting USBAM’s investment strategy for money market funds and is responsible for the management and trading of money market portfolios.
Can you discuss the current state of money market funds compared to 2022, and what you see happening in 2023?
2022 was a volatile year for the bond market and consequently money market funds. In 2020, we entered a prolonged zero percent interest rate environment lasting until March 2022. At that point, the Fed started an aggressive inflation fighting campaign bringing the federal funds rate from a range of 0% to 0.25% at the beginning of 2022, to a range of 4.25% to 4.50% by year-end. The pace and magnitude of rate hikes throughout 2022 caught investment managers off guard, leading to various rate calls that impacted performance and led to yield dispersion among funds in the same asset class.
Progressing into 2023, we are likely coming into the tail end of the Fed’s rate tightening cycle. Based on federal fund futures, the market anticipates a terminal rate in the 5.25% to 5.50% range. Sensitive to economic data and Fed speak, the futures can be volatile.
As fund managers wait for greater market conviction on the level and length of the Fed’s terminal rate position, money market funds in general remain very short duration. Weighted Average Maturities (WAM) for government/treasury money market funds are historically low, as fund managers position for additional rate hikes and look for advantageous markets to buy longer-term securities and lock in yields to benefit fund shareholders over time.
Timing extension trades is one of the main challenges facing money market fund managers in 2023. The competition for yield-sensitive investors has managers focused on the relevant economic and market data, as well as signals from the Fed, to help determine the best time to extend portfolio (WAM) metrics. The timing is critical as it is likely the short-end of the curve will be flat or inverted when managers decide to extend portfolios, and long-term investment opportunities will be in un-accretive securities, or have yields below the current yield of the fund.
The ultimate objective is to capture long-term yields before the Fed begins to ease, and more importantly, before significant expected easing is reflected in longer-term yields. The optimal execution window may be narrow, so managers should have a plan and be prepared to execute as opportunities arise. If managers extend prematurely, funds will hold securities yielding less than overnight assets longer than desired. Conversely, if managers wait too long, they may miss the opportunity to capture optimal yields. In either case, funds may find themselves underperforming versus their peer group, making the competition for assets more challenging.
Another component for fund managers to consider in the tightening cycle are the potential impacts and opportunities created by Quantitative Tightening (QT). QT could continue long after Fed rate hikes have stopped. To provide some perspective, take a step back to when the pandemic began in 2020 and the Fed’s balance sheet stood at around $4.1 trillion. Through the execution of Quantitative Easing (QE), which is the open market purchase of U.S. Treasuries and mortgage-backed securities, the Fed’s balance sheet increased to around $8.9 trillion. During the initial stages of QE, the market was able to absorb the additional cash pushed into the system as the Fed purchased securities. But eventually the banking system, flush with reserves, pushed excess cash to other areas of the financial markets, with money market funds one of the benefactors. In fact, as the money flowed into money market funds, the most efficient place for funds to invest was ultimately back at the Fed in “The Fed New York Reverse Repo Facility” or RRP, which incidentally has grown in balance to over $2 trillion.
Now, as the Fed shrinks its balance sheet by close to $95 billion a month, it is essentially taking cash reserves out the system and putting securities back in. As the Fed searches for the optimal level of reserves within the banking system, it could create a choppy yield environment as more securities enter into circulation and look for a home. It is important to respect the enormity of this process and not minimize its potential impacts. QT of this magnitude is new for all market participants and the experience could present investment opportunities or challenges for money market fund managers. In short, with the rate hike cycle likely coming to an end, and with the unknown impacts of QT, fund managers need to remain nimble to achieve competitive performance.
Is there a risk the Fed could “overtighten” and have an adverse impact on government funds or the money market space?
There is a reasonable probability the Fed could overtighten. To be clear, there has been some softness in recent economic data and inflation indicators appear to be moderating. These trends signal the Fed’s monetary policy is working. However, the Fed’s focus is on taming inflation and reaching the 2% long-term target level. The unemployment rate, (the Fed’s other mandate) is around 3.5%, near an all-time low. With the employment situation so healthy, the Fed will likely remain vigilant, and I would take them at their word regarding planned rate hikes to 5.25% to 5.50%.
Some experts suggest the Fed’s 5.25% to 5.50% target will ultimately be too restrictive and push the economy toward recession. If the economy does enter a recession, we suspect it would be mild. It is important to remember that Fed policy to this point has been aimed at slowing the economy to tame inflation. With U.S. employment on solid footing, if a mild recession helps them achieve their inflation goal, the Fed will see it as a victory.
What are the biggest risks when it comes to government bonds?
Market volatility around the debt ceiling certainly needs to be monitored. While outsized risks appear to be contained, geopolitical events could also bring some negative surprises that impact our forecasts. With all of that in mind, we anticipate a flatter rate environment this year, so I am not expecting as much interest rate risk compared to 2022.
Are there any bright spots or positive surprises that might lurk on the horizon?
There is a reasonable chance we see a soft or “softish” landing for the economy where the Fed can reduce inflation without causing the economy to slip into a substantial recession. There is the potential Congress could compromise and resolve debt ceiling issues with limited drama. A peaceful and reasonable end to the war in Ukraine would also be a positive for the capital markets and the world.