Wells Fargo Advantage Funds' latest "Portfolio Manager Commentary" reviews their major monthly stories of 2013 and discusses what's "On the horizon" for 2014. The latter section says, "As we prepare to close the books on 2013, we look forward to 2014 and the challenges that await us. New types of instruments, a shift in Fed policy away from asset purchases in favor of strengthened forward guidance, new regulations, and continuing developments on the credit front will all present their unique challenges." We excerpt from the "Overview, strategy and outlook" piece below.
Wells writes, "What seems unlikely to change is one of the foremost challenges facing money market investors -- extraordinarily low interest rates. We see a number of factors that could affect money market yields over the next year. On balance, they tend to suggest even lower rates to begin the year, with rates perhaps rising gradually by the end of the year but all within the near-zero rate range that has wearied investors for the past five years. That's right -- it's been five years since the Fed lowered its target rate to a range of 0 bps to 25 bps, on December 16, 2008. Even as the economy shows signs of life, money market investors are halfway to their own lost decade."
They explain, "Looking to the demand side, government securities will continue to be sought to collateralize over-the-counter derivative transactions, while the Basel III liquidity coverage ratio and other similar regulatory requirements will drive banks to hold more liquid securities, including government debt. Banks currently meet much of their liquid securities requirements with reserves held at the Fed, but as the Fed balance sheet potentially tops out later this year with the end of its asset purchases, the banks' needs for government securities should grow."
The comment continues, "On the supply side, 2014 will start with a reduction in T-bills outstanding, as the Treasury will issue fewer T-bills to make room for its new floating-rate notes, due to debut at the end of January. This net T-bill pay-down should squeeze rates early, as the timing will coincide with the debt ceiling reset in early February, but it should be relatively short-lived, persisting only until the debt ceiling is once again lifted. A more pervasive weight on rates will be the ongoing drain of repo collateral by the Fed as it continues buying securities via its QE program, potentially through most of 2014. Even though it has begun to taper its purchases, if the Fed reduces them gradually throughout the year, it will still stand to buy between another $400 billion and $500 billion in 2014. When (if?) QE finally winds down, repo rates could rebound a few basis points as the market attempts to find a new equilibrium."
Wells tells us, "The financial crisis, gone but not forgotten, will continue to be felt in the form of increased regulation on a number of fronts, with various impacts on rates. Banks have been and will be pressured to continually reduce their reliance on wholesale funding and increase the term of their liabilities, leaving them with a reduced need to finance their balance sheets in the repo market. The supplementary leverage ratio looks to be one of the primary levers to that end, as it would encourage banks to shrink their assets and liabilities, a task most easily accomplished by cutting their repo books. This has already taken place to varying degrees, and it's hard to see the process abating. Whether regulatory authorities have correctly diagnosed the problem, much less prescribed the right medicine, remains to be seen and will no doubt provide ample material for countless future Ph.D. candidates."
They add, "Regulatory and accounting changes are also expected to continue to compress the supply in the asset-backed commercial paper market, with supply of municipal variable-rate demand notes and tender option bonds also being eroded. Reduced supply leaves investors with fewer options, weighing on rates."
The Commentary says, "The two wild cards in the short end are both held by the Fed. They're potentially related, and either could significantly change the functioning of the money markets. First, the Fed could lower the interest rate it pays on excess reserves (IOER) from its current level of 25 bps. Depending on the degree of the change, such a move could materially change the willingness of banks to borrow through the repo and time deposit markets and park the proceeds at the Fed, a practice that currently drives a significant portion of money market activity. Such a move would obviously push rates lower, perhaps even below zero. The second big unknown is whether and how the Fed will use its fledgling RRP facility. Currently in a test phase through January, declaring the facility as permanent and full allotment could effectively establish a floor on rates, perhaps offsetting the effect of a cut in IOER. On the other hand, the Fed could just as easily declare the test a success and shutter the program until it's needed to control rates more closely during a tightening cycle."
Finally, Wells adds, "Overall, a Fed that is very committed to being very easy for a very long time, combined with regulations tending to increase demand and reduce supply, point to another year of low money market rates. Only a percolating economy and resulting nervous bond market wary of inflation seem to be risks to this view, but even then the Fed seems sufficiently steadfast that 2014 would be too early for it to move in nearly any circumstance. Our aim is to continue to assess the possibilities and developments in the markets, and their risks and rewards, and construct money market fund portfolios that will be resilient in the face of these challenges."
