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After five years of historically low cash rates, relief appears to be on this year’s horizon. OK, we know you’ve been promised rate-relief before, only to see it evaporate. But there’s good reason to believe it will bear out this time around. Economic growth clearly has picked up in the U.S. and elsewhere, including Japan and the eurozone. A two-year budget deal struck between House Republicans and Senate Democrats has lessened the possibility of more policy shock out of Washington. And perhaps most important, the Federal Reserve has begun to let off the gas. Add this altogether, and the result is a macroeconomic and geopolitical environment that argues for a move toward normalcy in the money markets, i.e., a steepening cash-yield curve.
The speed and magnitude of this shift remains very much in question, to be sure. This month’s initiation of tapering by the Fed is very modest, dropping the $85 billion in monthly asset purchases known as quantitative easing (QE) to just $75 billion. The post-December Federal Open Market Committee (FOMC) meeting statement and comments from Ben Bernanke in his subsequent press conference—his last as Fed chair—further reinforced the notion the target funds rate will remain effectively anchored at 0% well beyond the time when the unemployment rate drops below the 6.5% threshold, which could be breached as early as summer. In other words, any move up in short rates is going to be measured. But it seems to us that the takeaway from the December meeting is the bias on rates will be upward in 2014.
It’s not just about QE
While December’s unveiling of tapering plans was a bit of a surprise—it’s possible Bernanke wanted to act so incoming successor Janet Yellen could start with a clean slate, i.e., this burden of when and how much to taper wouldn’t be hanging over her head—we were encouraged the FOMC chose to split the $10 billion cut equally between Treasury and agency mortgage securities. It signaled the Fed is focused on the broader bond market and not just Treasuries, which generally are more volatile, prone to swings up and down on the on-again, off-again flight-to-quality trade whenever crises erupt. As long as the economic situation continues to improve without any major external shocks, we think the Fed is likely to bump up the pace of tapering as the year progresses. Even if it doesn’t, it will be done with QE by 2015.
Moreover, from a money market perspective, the Fed’s decision to extend and expand the overnight reverse repo facility that is being tested to manage its exit from all the extraordinary monetary accommodation of the past five years also was a positive. The reverse repo rate was dropped to 3 basis points, most likely to appease dealers concerned the previous 5 basis points was too high amid all the year-end window-dressing that typically causes supply to dwindle. But we would expect the rate will move back to 5 basis points as supply re-enters the market with the New Year. Also notable was that the Fed tripled the amount participants such as Federated can purchase. This vastly boosts liquidity in the marketplace, a plus for rates. When combined with a strengthening economy, this helps solidify our view money-market rates will start moving off their lows of the past several years. It may be some time before we get true normalcy, but given recent history, we’ll take it.