Month in Cash: Has the low-rate paradigm started to shift?
One of the challenges of doing these monthly updates the past few years is the underlying narrative hasn’t really changed all that much. Ever since the Federal Reserve unleashed ultra-accommodation five years ago this month, we’ve been dealing with a cash yield curve that shifted rapidly and sharply downward. Periodic eruptions in Europe and Washington have added the occasional drama and subsequent bump up in yields—and we could get another round of such the next few months as yet another potential showdown over a continuing budget resolution and debt ceiling looms. But the struggle for those who deal with the money markets has been and continues to be how to find value in an extremely low-rate environment.
If we look beyond this reality, however, there are signs this paradigm may be beginning to shift. We got a taste of this in the minutes from late October’s Federal Reserve policymakers meeting. They contained a more optimistic discussion than many expected, raising the possibility that quantitative-easing’s bond purchases could begin to slow as early as December. Everybody, including us, had discounted the time frame for such tapering well into 2014’s first quarter, after January’s budget resolution and February’s debt-ceiling deadlines are dealt with. While that’s still the likely case, the minutes indicated the Fed realizes QE can’t—and shouldn’t—last forever. To be sure, outgoing Fed Chairman Ben Bernanke and other Fed governors were quick to differentiate between tapering, which impacts the longer end of the yield curve, and tightening, which is largely on the cash portion. Even as the Fed tapers and eventually ends QE, it made clear tightening via increases in the target funds rate isn’t automatically up next. Labor market and inflation data would have to justify a hike and neither is anywhere close to such now.
Fed’s reverse repo test grades well
Secondly, it appears the overnight reverse repo program the Fed is testing in all likelihood will be extended beyond its January deadline, with the possibility that agency securities will be added to the mix. The reverse repo rates, which started at 1 basis point on Treasuries when the Fed first began offering them in September and now are at the maximum 5 basis points, have acted to set a floor in the marketplace by forcing banks and other overnight repo dealers to raise their rates to attract buyers (as we’ve noted before, why would a buyer pay 5 basis points for a low-risk bank repo if it can get the same rate from the risk-free Fed). This program, part of the central bank’s strategy to manage its eventual exit from the aforementioned extraordinary monetary accommodation, has helped to both push overnight repo rates up from the low single digits to the high single digits, and raise the shortest end of the curve (securities with maturities of 30 days or less). That’s good from a liquidity perspective. Just do the math: if a money fund manager keeps 30% of a portfolio in overnight securities, and the rate goes from 3 to 7 basis points because of the Fed’s action, the return on that portion will have more than doubled.
Finally, from an economic perspective, it feels as if we’re making progress. The ISM manufacturing and service sector gauges continue to go up. October was a relatively good month for employment, with job gains coming in at almost double consensus and prior months revised substantially up, too. Retail sales also beat forecasts. Housing sales and starts have hit a little bit of lull, some of which may be seasonal, but the numbers are coming off such a low base that as long as housing stays even neutral, the economy should be OK. Perhaps most notably, despite all the handwringing, the 16-day government shutdown doesn’t appear to have had much of an impact at all. True, it’s not a strong rebound or recovery. But it’s enough of one that, just as is the case on the long end of the yield curve, the bias for short rates may be more up than down in the coming year.