Gut check time
It’s time for a conviction trade in the liquidity markets.
Will the Federal Reserve’s next policy move be to cut the federal funds target range? We think yes, agreeing with most. Will it do so three times in the remainder of 2019 for a total of 75 basis points? We say no, putting us out of step. But even if it does, it is important to remember that it would be a moderation, not a plunge to zero or anything extreme. Rates could be steady at a lower level for some time or even rise. We don’t feel the end of this business cycle is nigh, and have been investing as such. It takes some resolve, but we are purchasing some floaters in the 12-month area, and we think cash will remain a crucial part of most portfolios.
At the heart of the issue is that we think the markets, policymakers and many economists have gone too far in forecasting so many rate decreases. Projections are for some version of cuts: 50 basis points in July with 25 either in September or December or maybe 25 at each of these meetings. (The last time the Fed moved half a percentage point was in the rush to zero during the financial crisis of 2008.) We don’t expect more than two quarter-point cuts this year. While the London interbank offered rate (Libor) has inverted, the U.S. economy isn’t acting like it is about to sink into a recession. Although many regional indexes have shown slowing activity and the housing market remains subpar, employment is still strong and retail sales, consumer and small-business sentiment are solid. Overall, you would have to call the economy moderating, but a month or two does not a trend make. So we need to watch a little further to see which way the data is leaning. In any case, even a percentage point drop would reflect a moderately growing economy, not a recessionary one.
The general tone among cash managers mirrors this view and many money fund investors also seem to agree. Flows into the liquidity space have been steady the entire year, especially into prime funds. Government funds still have the most assets, but proportionally, prime inflows are head and shoulders above the rest.
We will never know for sure, but it seems that the massive flight to money markets during the volatility in the fourth quarter of 2018 jump-started renewed confidence in them. Also, many investors seem to have accepted the new packaging for money market products following reform in 2016, with yield mattering most at this point. My guess is that these are people who followed the crowd that stopped using prime, despite the fact that they could have stayed in a floating NAV product.
We have been purchasing 3- and 4-month securities to try to keep yields as high as possible. But our conviction trades are in the 12-month area, in which we have been buying variable-rate instruments that reset every one or three months. If these stay steady or go back up again, we hope to benefit. We have not adjusted our weighted average maturity (WAM) ranges: 30-40 days for our government funds and 40-50 days for our prime and municipal funds.
The Treasury curve ended June with 1-month at 2.06%, 3-month at 2.14%, 6-month at 2.11% and 12-month at 1.96%. Libor ended June with 1-month at 2.40%, 3-month at 2.32%, 6-month at 2.21% and 12-month at 2.18%.