Money market funds are back in business now that central banks have boosted yields to levels not seen in years and the uncertain outlook incites investors to keep their powder dry. Market expectations are that official rates have not yet peaked, while volatility in fixed income appears set to continue.
At the start of March, investors appeared convinced that the European Central Bank (ECB) and the US Federal Reserve (Fed) would raise their key interest rates to 4% and 6%, respectively, and hold them at those levels for several quarters to ensure inflation returned to their 2% targets.
However, the financial stress then triggered by the closure of a regional bank by US regulators led markets to revise down the anticipated level of the central banks’ terminal rate in this cycle. Investors considered recessionary risks for the US economy had increased due to a likely contraction of credit as regional banks tightened their lending conditions for the small and mid-sized corporate sector.
We still believe in a scenario of a moderate recession in the US and anaemic growth in the eurozone. Markets remain wary, although the US authorities rapidly took measures to ensure market liquidity and financial stability.
While central banks have been prompt in announcing measures to maintain orderly markets, there is no indication that they will make concessions on the other part of their mandate – ensuring price stability.
Indeed, we believe stubbornly high core inflation will necessitate restrictive monetary policy for some time yet, particularly in Europe. Hence our expectation that official rates have not yet peaked.
This is also the message from the latest central bank forecasts and comments, including those made during the financial turmoil. For example, the ECB indicated that recent tensions in financial markets added uncertainty to the outlook but made no change to its baseline scenario requiring tighter monetary policy.
To quell inflation, the Fed signalled ‘some additional policy firming’ might be needed. Several Fed officials have reiterated that the federal funds rate should be raised above 5% (i.e., there are probably a couple more rate rises to come) and that a positive real rate should be maintained for some time.
Source: BNP Paribas Asset Management, as of 28 March 2023
What are the consequences for money markets?
Over the last year, the Fed and the ECB have made major adjustments to their monetary policies. The ECB has raised its deposit rate by 350bp from a negative 0.50% in the summer of 2022 to +3% today. The Fed has tightened policy by 475bp over the last year, taking the fed funds rate into the 4.75%-5.00% range.
After a long period of very low yields, money market funds are back in business. This is especially so given the considerable uncertainty about the economic outlook and prospects for risk assets in an environment of slower economic growth.
Source: BNP Paribas Asset Management, as of 28 March 2023
Risk/return profile favours money markets
With the current high level of yields in money markets and equity markets still fully priced, risk-reward profiles favour cash. Money market funds, especially short-term ones, can be seen as a perfect holding solution for investors in volatile equities or diversified products.
Even in an optimistic scenario of soft landing (which even the Fed deems unlikely based on the March Board staff forecasts), equity upside seems limited at current levels and unattractive relative to yields in money markets or short-term fixed income.
On the downside, even a mild recession may lead to equity markets retesting their previous lows and result in a meaningful downside. Money markets and short-term fixed income provides not only full protection on the downside but also optionality to buy risky asset classes should such a pullback occur.
In our money market investment strategies, we have sought to accompany the rise in key interest rates by implementing variable rate strategies, both for US dollar and euro-denominated strategies.
In terms of money market instruments, the unwinding of the ECB’s bank refinancing operations – in other words, the repayment of amounts borrowed in recent years under targeted longer-term refinancing operations (TLTROs) – is already leading to a significant increase in outstanding amounts on the Negotiable European Commercial Paper market from bank and similar financial issuers.
Bank issuers have shown interest in maturities of nine to 12 months. Non-financial issuers have offered very short maturities (between one and four months). The latter represents new diversification opportunities after a long dearth due to a shift to medium to long-term financing after March 2020.
For money market funds, this likely means more liquidity in the maturities where they are primarily active, and, potentially, better yields given the competition between issuers.
Compared to the levels in early 2022, the spreads on bank and non-financial (corporate) issues have widened, creating an additional 25bp uplift to money market fund performance. We see scope for a continuation of this expansion by a few basis points.
Given this significant issuance, we do not consider it appropriate at this time to diversify our exposure to Treasury securities, as valuations are too high.
A revision of the European Money Market Funds Regulation (MMFR) is planned for 2024. MMFs (Money Market Funds) came through the full-scale ‘stress test’ of the pandemic without a hitch. As the AFG (Association of French asset managers) recalled in its response to the European Commission’s consultation on MMFs in July 2022: “No European MMF has been suspended during the pandemic and each MMF has ensured its redemptions”.
We believe that recent events in financial sector institutions have demonstrated the effectiveness of our proprietary credit research, which ranks the credit quality of issuers in accordance with the European Credit Rating Agencies (CRA) directive. The CRA requires asset management companies to assess credit risks internally without relying exclusively on ratings issued by credit rating agencies.
In our view, the rate hikes and the normalisation of other aspects of monetary policy at the US Federal Reserve and the ECB (i.e., the slow reduction of their balance sheets) have increased the attractiveness of money market funds for investors. We will continue to manage our exposure actively while monitoring market opportunities.