Wells Fargo Advantage Funds' latest "Overview, strategy, and outlook", entitled, "A tale of two markets," tells us, "With the likelihood that the Federal Reserve (Fed) will raise its target federal funds rate from its zero interest rate bound sometime in the next year or two, the timing of that landmark move will come to dominate the money markets over the next year. Landmark might seem like a lofty word for what may be a modest 25-basis-point (bp; 100 bps equals 1.00%) increase, but any move higher after more than six years of zero -- brought about by a bevy of extraordinary stimulus measures (quantitative easing, Operation Twist, etc.) -- would be noteworthy."
It explains, "As the calendar advances and/or as the timing of the first rate hike moves closer in response to a stronger economy, the 13-month maturity limit for money market fund investments will begin to include time periods that incorporate expectations for higher overnight interest rates, and investments with a higher yield may finally become available to short-term investors. Over time, the market will refine its consensus opinion of the economy and the Fed, and that date will move around accordingly. Money market investors, who haven't enjoyed yield for years, will then potentially be exposed to something else they haven't seen in years -- namely, interest-rate risk."
Wells continues, "An expectation of higher interest rates likely will begin to affect the yield curve with the passage of time as we close the gap until the first rate hike; however, the market could be reshaped sooner, with uncertain timing, by preparations the Fed makes in advance of that hike. Advance work will be needed because the world of the $4 trillion Fed balance sheet is ompletely novel and foreign; in terms of institutional experience, the Fed could just as well be trying to raise interest rates on Mars. Conventional attempts to raise rates would be countered by the trillions of dollars of reserves in the system, so the Fed -- fully aware of the problem -- will need to act in this novel environment with novel tools."
They comment, "The Fed began taking these steps last September when it introduced and began testing its reverse repo (RRP) program. The RRP facility debuted with a per-counterparty limit of $500 million and took in $12 billion at 1 bp on its first day; by the end of April, after the Fed had raised the limit to $10 billion and the rate to 5 bps, the facility drew $208 billion from 77 different counterparties. When it was announced, we thought the RRP facility could prove to be a game changer, especially in the government money markets, and this seems more likely now than ever. At the same time, the supply of eligible money market investments continues to erode across the curve and in virtually all sectors: regulatory pressures are shrinking the traditional repo market; bank issuance is being pushed into longer maturities; Fannie Mae and Freddie Mac are in a gradual state of wind-down, constraining agency issuance; asset-backed commercial paper issuance is a small fraction of what it once was; and the higher tax receipts generated by a strengthening U.S. economy are keeping Treasury bill (T-bill) issuance muted. In the form of the RRP facility, the Fed is seemingly becoming the investment of last resort. The continuing growth of the RRP facility is highlighted in the chart below, with usage not only gradually increasing over time but also moving sharply higher when market repo rates fall near the Fed's RRP rate."
Wells' Portfolio Manager Commentary adds, "Recent activity in the T-bill market, however, demonstrates the potential difficulties the Fed will encounter as it attempts to control short-term rates in a system awash with cash. Much as the federal funds market has not been bound by the Fed's official interest-rate target due to leakage in the system, the government securities market has traded below the floor set by the RRP rate. As T-bill issuance rose and then fell with the Treasury's seasonal cash outflows and inflows, respectively, a T-bill drought pushed yields well below the Fed's RRP rate. At month-end, T-bills with maturities out to three months yielded 1 bp, while T-bills with six-month maturities yielded 4 bps. Because of leakage in the system, largely the result of actions by investors who have no access to the RRP facility, this segment of the government money market is trading well through the Fed's RRP rate. To even approach the Fed's overnight rate, investors must move more than six months out the curve. The Fed has, however, been more successful in keeping repo rates close to the RRP level, as those have generally stayed within 1 bp of the Fed's level, while prime and municipal money market instruments have mostly traded above it."
In other news, Federated's latest "Month in Cash" writes, "The Fed repo man is on our side." It says, "Quantitative easing and zero-bound interest rates get all the attention when analysts and investors talk about the Federal Reserve. Certainly speeches in April by Chair Janet Yellen and the Federal Open Market Committee statement released at the conclusion of the FOMC meeting on the last day of the month affirmed that it will continue to base its policy decisions on a broader, more qualitative approach rather than anchoring actions to specific numbers of unemployment and inflation (although policy is still data dependent). But much can be read into its motives from an end-of-quantitative-easing perspective. When the FOMC announced in its recent meeting that it will taper the amount of monthly asset purchases on the open market down to $45 billion a month, it also signaled faith in an improving economy. So policy is steady as we go and that is where we will be for some time, although it looks like we are pulling out of the winter slump."
The piece adds, "But for cash management, a lesser-known program has been just as big a factor as QE. The New York Fed's Overnight Reverse Repo Facility -- a relatively new Fed program that is aimed at giving the central bank better control over short-term rates -- has kept money-market funds in a better position in 2014 than they probably could have been. The facility, first launched as an experiment and now afforded operation status, has helped to provide a floor to the market even in this time of exceptionally low rates."
