Cash & Liquidity ManagementCash ManagementPracticeTactical Opportunities in Liquidity Investments

Tactical Opportunities in Liquidity Investments

Over the past three years, money market funds have experienced both the worst and best of times. After a rather lean period in 2003, when the federal funds target rate fell to a 47-year low of 1%, two years of consecutive, step-wise rate hikes by the Federal Open Market Committee (FOMC) have helped buoy the yields and corresponding investor interest in these funds. Therefore, the value of maintaining long-term strategic exposure to triple-A-rated money market funds has been re-affirmed. But now treasurers and corporate cash managers may find a shorter-term, tactical reason to increase their allocation to these vehicles.

Money market yields rise with rate hikesSource: Bloomberg

Why is that? Again it has to do with the Fed. The FOMC recently announced a pause in its ‘measured’ pace of tightening, holding the target fed funds rate steady. The key question for investors, however, is what exactly such a pause may entail, and whether it may suggest a future resumption of future tightening by the Fed. However, in its entire history, the Fed has never paused in a tightening cycle only to resume a campaign of rate hikes. Sometimes it has held rates constant for several meetings, but the next move has always been a cut (it’s true that pauses are not unheard of – they occurred three times, in 1999, 1994 and 1988, but all of these happened in periods of declining rates).

Many analysts have therefore begun to shift their macro forecast from an environment of ongoing rate increases to one of flat and, eventually, declining rates. This is true even in the unlikely event that the Fed resumes its rate-tightening campaign for what would surely be a brief period. It is this likelihood of monetary easing ahead that has increased the appeal of money market funds in the eyes of corporate cash managers. Such a prospect of monetary ‘easing’ creates an important, tactical opportunity for corporate treasurers seeking additional yield.

Timing the Yield Advantage

The investment question for corporate treasurers is a twofold decision: which mix of instruments offer the best match for their objectives of security, liquidity and yield, and how that mix should change over time, depending on the market environment. Right now, as the FOMC nears the end of its 17 consecutive quarter point rate hikes, money market funds may become a place not only to safely park excess liquidity, but a source of potential investment alpha beyond the returns offered by direct investment in commercial paper, bank deposits and other vehicles.

The explanation for this yield advantage is simple: every drop in interest rates paid on direct investments in commercial paper or bank deposits isn’t matched immediately by a fall in money fund yields, because money fund portfolios include instruments purchased earlier and still paying interest at higher rates. In other words, the yield on bank deposits and commercial paper is marked to market, and such ‘spot’ rates during this period tend to be lower than the legacy yield of assets held within a money market mutual fund, bought in a previous, higher-rate environment. For example, the yield of a money fund with an average weighted maturity of 60 days, for example, would reflect the level of rates that existed two months prior, not those of a bank deposit on that day.

When Lagging Means Leading

As a result, when interest rates are steady or declining and spot yields drop, money market funds will generally lag this decline in the rest of the market, temporarily offering investors higher returns than those obtained through direct investment. On the other hand, when short term rates rise, investors may find a tactical opportunity in rolling short term debt obligations (commercial paper or bank deposits) directly rather than waiting for the older securities in a money fund portfolio to mature and be replaced by higher yielding holdings.

Consider the dramatic decline in short term interest rates to record lows after 9/11, which for a limited time made ‘lagging’ money market funds very attractive to institutional purchasers. In that period, the percentage of short-term business assets held through money market funds jumped from 19% to 27%, only to drop down to 23% in 2003 as rates levelled off at record lows, making direct investment temporarily more attractive to institutional investors.

From Lags to riches: Cash Investors Await Window of OpportunitySource: iMoneyNet

Similar periods, when short term rates declined and yield curves flattened (or inverted) occurred in 1997-1998, and 1994-1995. These periods coincide with a cycle of monetary easing by the Federal Reserve, and resulted in a reduced (and in some cases inverted) yield curve at the very short end. Likewise today, with the end of the Fed’s current tightening cycle expected soon, a similar yield opportunity should arise, making money market funds even more attractive to the institutional investor.

Short-end inversion creates tactical yield opportunitiesSource: Bloomberg

When the Best Strategy is to be Tactical

It should be remembered that while there certainly will be periods where money market fund yields lag direct investment, the overall return of these safe and liquid vehicles during a complete market cycle tend to be superior. But for corporate cash managers looking to satisfy a yen for yield – increasingly important in a period of historically high cash reserves – a flexible strategy of tactically shifting excess reserves between direct and indirect (MMF) investment may offer compelling benefits.

Comments are closed.

Subscribe to get your daily business insights

Whitepapers & Resources

2021 Transaction Banking Services Survey
Banking

2021 Transaction Banking Services Survey

2y
CGI Transaction Banking Survey 2020

CGI Transaction Banking Survey 2020

4y
TIS Sanction Screening Survey Report
Payments

TIS Sanction Screening Survey Report

5y
Enhancing your strategic position: Digitalization in Treasury
Payments

Enhancing your strategic position: Digitalization in Treasury

5y
Netting: An Immersive Guide to Global Reconciliation

Netting: An Immersive Guide to Global Reconciliation

5y