Month in Cash: Don't get spooked by the headlines
There’s no doubt last month’s debt-ceiling showdown was unnerving, if for no other reason than it was impossible to escape the scary headlines. But the reality is the consensus view in the money market was it was pretty much steady as she goes. That may not sell newspapers, attract TV viewers or generate a lot of website clicks, but it does create opportunity for those who remain calm and stick to business. For example, when a few major traders garnered a lot of attention for getting out of very short Treasuries, helping cause yields on one-month T-bills to reach as high as 60 basis points in the hours just before a deal was struck on Oct. 16, we were able to add some inexpensive Treasury paper to our prime funds. This isn’t something we often do. In fact, the last time we actually held any Treasury securities in our prime funds was for liquidity purposes pre-Y2K, when it was feared computers may trip up as the year rolled over from 1999 to 2000. This time, the move was made simply to take advantage of yields that were reflective not of default risk but of liquidity changes—as a few major traders got out of very short Treasuries, supply and thus yields rose significantly. It’s a two-way market, and from a yield perspective, we along with many others were on the more generous consensus side of this trade.
That said, the government cash market was quick to normalize once the debt-ceiling can got kicked again, this time to early February. That is to say, Treasury yields have fallen back to low single-digit pre-government shutdown levels, and the overall money market remains settled in the extremely low rate environment with which we’ve been dealing for longer than I care to acknowledge. The good news is there has been a little more positive tone of late along the short end of the cash yield curve—overnight to a couple of weeks—thanks to the Fed. As you may recall, the central bank in September began testing its plan for using overnight reverse repos as way to manage its eventual exit from extraordinary monetary accommodation by selling overnight securities in the marketplace. While the rates are low—the first batches were sold at 1 basis point, more recent sales have been at 2 basis points and the Fed could go as high as 5 basis points—they have acted to set a floor in the market by forcing banks and other overnight repo dealers to raise rates to attract buyers (i.e., why would a buyer pay 2 basis points for a low-risk bank repo if it can get the same rate from the risk-free Fed?). This has helped push rates on overnight repos up from the low single digits to the high single digits.
Rate relief may be on the way
The cash market got another lift from the Fed when, in their post-meeting statement following the Oct. 29-30 Federal Open Market Committee Meeting, policymakers didn’t close the door on any kind of potential tapering move this year. We still think the Fed won’t begin paring the $85 billion in monthly Treasury and agency purchases until March at the earliest, but the statement wasn’t as dovish as the market was expecting. Policymakers didn’t really change their slightly more bullish economic outlook since they last met in September—they didn’t even reference the government shutdown. Maybe it’s just you read into the statement what you want to see, but it seems that message between the lines was the bias remains for rates to rise over the course of 2014 and for the yield curve to steepen. The Fed reiterated that whatever it does will be data dependent, and while the numbers may be messy for a bit because of all the temporary furloughs from the 16-day shutdown as well as the delays in awarding contracts and actually collecting data, many fundamentals still appear good. Third-quarter earnings have been relatively strong, state and local government finances continue to improve, the federal deficit continues to shrink and the economy continues to grow albeit sluggishly.
To be sure, the potential for another Washington showdown exists, starting with the Dec. 13 deadline for a House-Senate conference committee agreement on a budget, followed by the Jan. 15 deadline for approving a budget, followed by a Feb. 7 deadline for extending the debt ceiling again. These cascading deadlines alone argue for the Fed to play a waiting game before acting. But from our perspective, the outlook for money market rates is improving. Supply and liquidity in the marketplace are good. And while we don’t think the Fed will move its target fed funds rate at all next year, we do expect it will begin to taper and to continue its reverse repo program in a larger way. Yields will remain low, make no mistake, but they should widen from current levels somewhat.