NEW YORK--(BUSINESS WIRE)--As the Fed approaches its first rate rise since 2006, money funds and other short-term investors are contending with different conditions from previous rising rate cycles, leading to greater market uncertainty and potentially more volatility in short-term rates, says Fitch Ratings.
A significant question for investors revolves around the mechanics of two monetary policy tools and their success in raising rates. Following years of low short rates, the target Fed Funds rate will soon be set between two boundaries. The target rate's upper bound will be set through interest payments on banks' excess reserves held at the Fed and its lower bound will be set through reverse repurchase transactions with counterparties, including money funds. While the Fed has had some experience utilizing these two new tools, they have not been fully tested under an actual liftoff in the target rate.
In particular, the Fed has been ambivalent about transacting with money funds, which the Fed does not regulate. The Fed has instituted a $300 billion cap on the reverse repo program, while also making it clear that the program is temporary. Unless the cap is raised, it may hinder the Fed's success in raising rates if excess demand spills over to other parts of the market and pushes yields down.
The multi-faceted shifting environment for cash and short-term investments also creates an unusual level of uncertainty. Money fund reform in the US is pushing hundreds of billions of dollars from corporate and bank debt investments toward government securities. At the same time, bank regulations are incentivizing banks to shed excess, noncore institutional deposits, often sending the cash into money funds.
Finally, a rising rate environment itself usually causes shifts in investments, from bank deposits and money funds into direct short-term debt like Treasuries and commercial paper. However, short-term debt in many sectors is in short supply, exerting downward pressure on yields for these securities. In addition, because of the prolonged period of low interest rates, many of the money fund clients who are driven primarily by yield have moved to other products. Investors that remain may continue to invest in money funds due to the funds' other characteristics, such as diversification.
Some US money funds have struck defensive positions in bracing for liftoff. The primary indicator of this has been by switching their maturity positioning a number of times in reaction to conflicting messages from the Fed. After steadily decreasing weighted average maturities (WAM) since November 2014 in anticipation of a rate hike, US prime money funds pivoted to extend WAMs in September when the Fed did not raise rates as expected. However, only a month later the funds again switched their portfolios to account for an anticipated rate increase in December, and now stand at an average of 31 days, down from 44 days in November 2014. US money funds' WAMs are likely to remain short as interest rates are expected to rise throughout 2016.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.