Month in Cash: Unknowns at the Fed


Recent headlines about the Federal Reserve describe a central bank with little drama and much consensus. It’s a near certainty it will raise rates at its next policy meeting ending on Dec. 13. And most think the economic philosophy of the soon-to-be confirmed new chair, Jerome Powell, toes the line with that of the departing Janet Yellen. He agrees with her outlook and has voted with her every time. The narrative, then, is of a smooth transition: the Fed will look and act just like it has in the last few years.

As with an economic report, however, you need to look past the headline into the details. They tell me this story might be premature. When Yellen departs there could be as many as four empty seats on the board of governors and thus the policy-setting Federal Open Market Committee (FOMC). And if New York Fed President William Dudley makes good on his intention to retire in mid-2018, there’s a potential for five empty seats. Even if President Trump names more nominations soon—as he did yesterday with Carnegie Mellon University economist Marvin Goodfriend—the confirmation hearings will take months to complete. Eight, let alone seven, voters are too few to be making far-reaching decisions, especially as the Fed navigates out of this era of historically low rates and quantitative easing. Even nine governors if Goodfriend comes on board quickly is too few. And having the regional presidents control the voting rather than the board is also a non-starter with the market.

But the opposite should also be a concern. When these posts are filled, what will the Fed’s makeup be? Five new FOMC or voting members could swing a relatively neutral Fed to more dovish or more hawkish positions. You don’t need me to tell you the impact that policy shifts can have on the economy. Each added member will bring new uncertainty for the markets.

The other uncertainty is how the tapering of the Fed’s massive balance sheet will affect the yield curve—especially, for cash managers, its short end. At the end of this year, the Fed will have retired $30 billion in Treasuries and mortgaged-backed securities and that number will rise in upcoming quarters. The reissuance for that debt has meant an uptick in supply of Treasuries and even slightly higher rates, both welcome developments. But this massive roll-off is uncharted territory. While we think it should go smoothly no one knows for certain.

The London interbank offered rate (Libor) rose at a good clip in November, so we know that it is possible to maintain normal operations during the taper. I say normal because it is expected that Libor rises ahead of expectations for a Fed rate hike and in anticipation of year-end trading/supply pressure. We’ve also had pretty good economic news of late, especially the all-important retail sales for this holiday shopping season, and that can push rates higher. One-month Libor rose from 1.24% to 1.35% and 3-month from 1.38% to 1.48%, both approximately 10 basis-point increases. If as expected the FOMC takes rates to a target range of 1.25% to 1.50% at the coming meeting, cash rates on the money market yield curve should continue to rise. So we have slightly shortened the weighted average maturity (WAM) for our government, municipal and prime funds, but they remain in their target ranges of 30-40 days for govies and munis and 40-50 for prime.