Month in Cash: Light at the end of the tunnel
In a month that saw continued albeit choppy economic improvement, the most significant news in August from the money market’s perspective emanated from an event that actually occurred in July. That’s when Federal Reserve policymakers wrapped up their latest meeting, the minutes of which weren’t released until Aug. 21. Notable in the Federal Open Market Committee (FOMC) comments were two things: committee members appeared wedded to finalizing a framework for ending quantitative easing (QE) when they next meet on Sept. 17-18, with a tapering of the $85 billion in monthly Treasury and agency mortgage-backed securities purchases likely starting in October. Secondly, and more significantly from our viewpoint, the minutes indicated policymakers expect to use overnight reverse repos to help manage the Fed’s exit from its extraordinary monetary accommodation of the past five years.
What does this mean for savers and money fund investors? After living with extremely low interest rates since 2008, some relief may loom on the not-too-distant horizon. To be sure, events between now and the September meeting could forestall immediate movement by the FOMC. Fed Chairman Ben Bernanke et al have made clear that whatever decisions they make will be driven by the data, the bulk of which so far is suggesting the economy is strong enough to stand on its own. It hasn’t been great, mind you. Manufacturing and employment haven’t picked up as much as many were expecting, housing has hit a bit of speed bump as higher mortgage rates appear to have made some potential buyers squeamish and there always are geopolitical tensions, the latest being Syria. Still, with housing off the floor, unemployment trending down and the consumer pretty well situated, the Fed appears set to act sooner rather than later.
It’s all about supply
How much and how fast the Fed pulls back remains debatable. It will come in two phases, the first of which is to get rid of QE. Earlier this summer, when the economic outlook was brighter and the market perhaps a little too optimistic, we anticipated this may be wrapped up by year’s end or so, with the Fed culling purchases $15 billion to $20 billion a month in the fall. Now, with the outlook a little murkier, it’s possible the Fed will take a more gradual approach, i.e., a monthly drawdown closer to $10 billion to $15 billion, delaying QE’s demise until the end of next year’s first quarter if not a bit beyond. Either way doesn’t matter that much to the money markets, given that as soon as the Fed begins to exit from the Treasury and MBS markets, supply should rise, helping lift yields across the curve.
The second phase—the reduction of the roughly $3 trillion the Fed has added to its balance sheet since launching unprecedented easing—won’t likely come until phase one is complete. But we expect overnight rates to be impacted sooner as the money market reacts to the realization that a lot more supply is heading its way at rates set by the Fed, not the banks. That arguably was the biggest surprise in the minutes. Everyone knew the Fed was planning to use repos as part of its unwinding strategy to get all those idle assets off its books. But the thought was it would use term transactions, those dated longer than 30 days—not overnight repos. And with the Fed setting the rates, it’s very possible we could see overnight repos quickly rise to the high end of the Fed’s current 0% to 0.25% range on its target federal funds rate. That would be very welcome in a money market where overnight repos and Treasury bills currently are pricing in the low to mid single digits and London interbank offered rates (Libor) barely budged over the month, hovering at 52-week lows all of August.