MMFs Headed Higher?

This month’s main article, MMFs Headed Higher?, compares the volatility of bond yields, credit spreads, and equity markets with the far more placid money market fund (MMF) yields and discusses when MMF yields may finally begin to climb.

Also included are the following themes:

• Credit Vista: Bankrolling another rate-hike cycle

• Trading Vista: Deal with it!
  

MMFs Headed Higher?

Eric Souza, Senior Portfolio Manager

Personally, I’m not a big fan of the steep ascents and stomach-churning drops characteristic of roller coasters. Investors can probably relate — especially given the volatility of the first quarter of 2022. While bond yields, credit spreads and equity markets seem to be on a metaphorical roller-coaster ride lately, money market fund (MMF) yields have remained far more stable. Most investors expect to see some activity from MMFs in the near future. The question is, when will the climb commence?

The average yield from government MMFs has remained in a 1 to 3 basis point (bps) range since the Federal Reserve cut rates in 2020. The expectation that the Fed will raise rates several times this year — perhaps as early as March — leads many clients to wonder about the projected path of rate hikes and how they will affect MMF yields.

For clues on how this situation may unfold, we can take a look at the last time we were in a zero-interest rate environment. During the last rate-hike cycle, the Fed moved at a more measured pace over several years with gradual increases. But now, perhaps in the face of some startling inflation readings, the Fed is expected to make several hikes in the coming months.

Although the bond market has priced in this hawkish pivot by the Fed with 1-year Treasury yields rising from 7 bps in October 2021 to over 1% currently, MMF yields are still anchored low, as they are more closely tied to the federal funds rate, which has not increased just yet.

However, don’t expect an immediate move in MMF yields. Government MMF yields that allow the use of repos should see a swift move higher, since repo rates reset more quickly, whereas government and Treasury funds that do not allow repos will see a slight lag. With that said, MMFs have been preparing for higher rates, with an increased allocation to overnight investments and shorter maturities, so there is a likelihood of a quicker move to higher MMF yields than in past cycles.

Regarding the slower path of increasing MMF yields, this phenomenon was illustrated in December 2015 when the Fed raised the federal funds target to a range of 0.25% to 0.50%. At that time, government MMFs on average took 13 to 27 weeks to reach yields of 0.25%. The yield range for funds with no repos was much wider, with some funds taking as little as eight weeks to climb, while some took close to one year before offering higher yields.



Although there is still plenty of uncertainty regarding how many times the Fed will actually raise rates and how quickly they will shrink their balance sheet, one thing we know is the overall trend for rates is pointing up, which will eventually lift overnight investment yields. For this cycle we will not need to wait an entire year between rate hikes as we did in 2015 and 2016. As a result, investors will likely benefit from higher overnight rates more quickly. Still, patience is required.

So are there any action items for investors in the face of a new, more aggressive rising rate cycle? We still advocate for a diversified portfolio with an allocation to spread product (credit and asset-backed securities [ABS]), high-quality securities (such as US governments) and overnight investments (such as government MMFs and repos). The roller-coaster ride for bond yields and other more volatile areas of financial markets will likely continue, but the path for MMF yields is headed in one gradual direction: up.

Credit Vista: Bankrolling another rate-hike cycle

Fiona Nguyen, Senior Credit Research Advisor

Thanks to the Fed’s clear communication, market participants have been preparing for the Fed to reverse course on quantitative easing and begin a new tightening cycle. In fact, the Fed has conditioned markets to expect a somewhat aggressive rate-hike cycle amid persistent inflation pressures. As a result, the forward yield curve has flattened considerably, reflecting the market’s outlook for higher short-term rates and, possibly, weaker long-term economic growth.

In the past we have discussed the impact that higher interest rates can have on various sectors. In general, banks are most sensitive to rate movements. After years of limited earnings — an upside due to a prolonged low-interest rate environment — the banking sector can finally rally from the Fed’s policy pivot, as banks stand to reap the benefits of revenue windfalls. Since banks generate interest income by paying short-term rates on deposits while receiving long-term rates on loans, their margins are sensitive to the difference between the two (i.e., the steepness of the yield curve). The best measure of bank profits linked to yield-curve movement is the net interest margin (NIM). Simply put, NIM is a measurement of how a bank makes profits from its credit product revenue minus the interest it pays on savings accounts and products.

To be clear, this is not the first time a tightening monetary policy cycle has been accompanied by a flattening yield curve. For the US banking industry, the 2015–2018 rate-hike cycle was also followed by a flattening episode (even an inverted yield curve for a short spell) as well as slow lending growth. Yet the industry still managed to eke out decent net interest margins and, by extension, profitability. If there is an observation to be drawn from the last cycle, it is that the slope of the yield curve can have limited downside impacts on bank profitability. In fact, from 2016 to 2018, the industry wide NIM growth ranged between 7% and 9%. During this time, the banks benefited from having asset-sensitive balance sheets in a rising rate environment, which resulted in expanding NIM. However, it’s important to note that when faced with a flattening yield curve, different types of financial institutions might fare differently. As an investor, this is critical.

A study by the Federal Reserve of Chicago¹ examined two different banking business models — retail banks and wholesale banks — in various periods of yield curve flattening. The study found that the retail bank is funded mostly with retail deposits and generates revenue from short-duration, variable-rate loans (e.g., auto and commercial loans). In contrast, the wholesale bank typically relies more on market-based funding, such as repos, and earns revenue from longer duration, fixed-rate assets (e.g., 30-year fixed-rate mortgages). As the Fed raises short-term rates, retail banks can start charging more for loans but are unlikely to hike deposit rates immediately, partly owing to low-rate sensitivity on the part of retail depositors. As a result, a retail bank’s NIM can still widen even as the yield curve flattens.

In contrast, a wholesale bank with a limited retail deposit base tends to experience narrow NIM expansion or even contraction. The majority of their liabilities are made up of institutional funding, which tends to reprice in tandem with short-term rate hikes. On the asset side, the yields on its fixed-rate, long-duration assets don’t move nearly as much, given the shape of the flat yield curve.

It’s worth noting that today the industry’s business models have evolved considerably. There no longer exists the pure-play wholesale bank type, as post-financial crisis regulations pushed banks to reduce their reliance on wholesale funding and, to some extent, reduce the duration of their assets. That helps explain the NIM defensiveness that we saw in the last cycle.

All in all, as market participants focus on how many hikes the Fed will crank out this year, banks seem to be ready to start the tightening cycle no matter how aggressive the Fed becomes. The industry is in a good position to take advantage of a rising rate environment. Barring the impacts of the current geopolitical conflicts and sanctions, bank investors should expect healthy earnings over the next several quarters.

^1. https://www.chicagofed.org/publications/chicago-fed-letter/2018/406

Trading Vista: Deal with it!

Jason Graveley, Senior Fixed Income Trader

Volatility has become a fixture in markets over the last month, and investors might need to get comfortable with it. The fluctuations in Treasuries and across financial markets are being driven by several variables, including changing monetary policy, economic data expectations and, most recently, rising geopolitical tensions. The 2-year Treasury benchmark, one of the most common front-end benchmarks for portfolio execution, has seen sudden and steep yield changes. In February alone, overall yields have moved more than 45 bps higher, while also retracing more than 25 bps over a separate three-day trading period. Both moves are two to three times the monthly standard deviation, when compared to the fourth quarter of 2021. Headlines associated with the Russia-Ukraine crisis have been unsettling, and the market is responding sharply, both positively and negatively, as sentiment shifts back and forth. One valuable measure of the market’s overall tone is the volatility index (VIX), which represents expectations for equity market volatility over the coming 30 days. As February drew to a close, the VIX was at its highest point on a trailing 12-month basis, and it continued to rise (above 30) during the first week of March. It appears the market is signaling that elevated volatility may persist for some time.

In addition to the volatility the market has priced in benchmarks, spreads have also been under pressure. The Bloomberg Barclay’s Short-Term Credit Index, which focuses on credit inside one year, has seen its aggregate spread more than double over the last month. This makes perfect sense, given the current backdrop. Investors are digesting continuous market headlines, while trying to handicap the potential domestic economic implications of the escalating Russia-Ukraine conflict. Sentiment has turned defensive, and there is limited demand for investors willing to commit to the long end of the curve. Conversely, money markets attracted more than $75 billion in inflows over the final week of February.

Looking ahead at market expectations for monetary policy, the current consensus is that there will be six rate hikes over the next year. Rising geopolitical concerns have dampened some of this outlook, but the expectations have still resulted in a very steep money market curve, where even short-duration portfolios can capture yields above 1.3% on an issuer basis. With benchmarks and spreads widening, all-in portfolio yields continue to be on the rise.

Despite heightened volatility and an evolving geopolitical backdrop, there has been no change to our investable universe, and our approved corporate issuer fundamentals are expected to remain strong. Portfolio duration remains a focus, particularly as the rate environment evolves. However, the way we structure portfolios can help us mitigate risks and deal with the volatility. Weighted-average credit quality remains high across our client portfolios, with typically more than 50% of holdings invested in AAA-rated securities or equivalents (including MMFs, ABS and government bonds). We also allocate across the maturity spectrum and keep a liquidity buffer for changing business and investment needs. Thus, even in the face of heightened uncertainties, we remain comfortable managing portfolios in this new, more volatile environment. In other words, we’re dealing with it.

Source: Bloomberg, Silicon Valley Bank as of 2/28/22.