Month in Cash: The waiting game

07-01-2017

With three Fed rate hikes in six months and U.S. money market reforms almost nine months behind us, the money markets in many ways are starting to approach normalcy. Daily prime fund net yields are back above 1%, with government and tax-free fund yields not lagging by much. This rise is likely to continue over the course of this year and next as the conversation on monetary policy isn’t whether more rate increases are coming, only how many and how fast.

But the prime money markets still find themselves to some extent playing a waiting game. While fund assets industrywide are up about $30 billion year-to-date, a significant increase on a relative basis, on an absolute basis, they’re still well short of their pre-reform levels. Fund rates continue to move up with each Fed increase while bank rates remain sticky, giving prime funds a widening yield advantage.

We know there’s plenty of supply out there. At its industry conference in June, Crane Data estimated there currently is $9 trillion of short-term deposits in the marketplace. We would expect some of that to eventually work its way over to prime funds. The holdup, from what our clients are telling us, is the “herd mentality’’ among institutions. Until one makes the move, no one is making the move to shift significant sums back into prime funds, which for the most part are the same instruments where they once parked their cash. Indeed, as we noted last month, new floating net asset values (NAV) on prime and tax-free funds are hovering very close to the industry’s historical $1 NAV standard to the thousandth decimal place.

The waiting game aside, we see the Fed continuing with rate normalization. June’s 25 basis-point increase, the third since mid-December 2016, had been priced into the markets, lifting the target fed funds range to 1-1.25%. What was a bit of surprise was the specificity of the balance-sheet reduction plans, which likely was done to appease the bond market and avoid a repeat of 2013’s taper tantrum. The Fed said it will start removing $6 billion of Treasury bills and $4 billion of mortgage-backed securities (MBS) off its balance sheet each month, gradually raising the amount to $30 billion of Treasuries and $20 billion of MBS—$50 billion total—over a six-month period. It didn’t say when it will initiate the plan, but we wouldn’t be surprised to see it come in Q3, before the year’s final rate increase.

One point the Fed has made clear in the last few weeks is that, despite headline and core inflation gauges that have rolled over and economic data that has reflected some softening, it is moving ahead with policy normalization. New York Fed President William Dudley, vice chair of the policy-setting Federal Open Market Committee, last week said he sees no signs the Fed’s actions have harmed the economy. The reality is a 2% target funds rate is considered neutral and we are nowhere near that. In my opinion, describing the Fed’s actions as “tightening’’ when rates are still historically very low is a misnomer. It’s more like the central bank is being less accommodative.

As far as the money markets are concerned, one plus to the balance sheet-reduction plan is the bulk of reissuance in the marketplace likely will come in the form of Treasury bills. That’s the path of least resistance for the Fed, in part because there is so much government supply—capacity, if you will. This should have a favorable, i.e., upward impact, on short-term yields, which is where we are focused.

For now, we are holding the average weighted maturity (WAM) range at 30 to 40 days for government and municipal money funds and 35 to 45 days for prime money funds. If we do buy anything longer-dated—12- to 13-month maturities—it tends to be in floating-rate securities.