The Federal Reserve raised interest rates yesterday for the third time in 2017 and the fifth time in 3 years. The Fed continues to expect 3 more hikes in 2018, and money market fund yields, which have been inching up in anticipation of the hike, should move higher in coming weeks. The Federal Reserve's FOMC statement says, "In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1-1/4 to 1‑1/2 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation." We review the Fed's latest move, as well as research pieces from Wells Fargo Funds and the Bank of Japan, below.
The Fed's statement also tells us, "In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data."
Wells Fargo Asset Management's "Portfolio Manager Commentary" says, "Yields on short-term U.S. government securities moved higher in November, reflecting growing expectations for positive developments from the two main drivers of rates: Federal Reserve (Fed) policy and the supply/demand equation. On the Fed front, consistently solid economic data, including stabilizing prices (suggesting inflation may be ready for a slow grind higher), has combined with unwavering Fed messaging to not only make a December rate hike a near certainty but also put further rate hikes in 2018 firmly on the table. The Treasury bill (T-bill) market's embrace of the likely 0.25% rate hike in mid-December is reflected in the steady march higher in 3-month T-bill yields as the Fed meeting approaches. [T]erm premia, as measured by the excess of the T-bill yield over the then-current rate on the Fed's reverse repurchase agreement (RRP) program—currently at 1.00% -- have increased earlier in the weeks leading into the potential rate hike than in the four previous tightening moves in this cycle, dating back to December 2015."
Wells explains, "The T-bill market appreciating the approaching hike to a greater degree than previous hikes could be due to several factors. First, it could reflect growing Fed credibility, a belief that the Fed will do what it has suggested it will, bolstered by economic data that has continued to be solid. Second, bringing us back to the supply/demand market dynamic, it may reflect the accumulated weight of a steady increase in T-bill issuance throughout the fall. The total amount of T-bills outstanding rose $252 billion from June 30, 2017, to the end of November 2017, providing a supply shock that, all other things being equal, may push yields higher."
They add, "A good indication of the impact of the larger supply on the market has been a reduction in the amount of money placed with the Fed in its RRP program.... Over the period from the effective date of the change in money market fund (MMF) regulation on October 14, 2016, through October 31, 2017, the average daily RRP take-up was $161 billion. That regulatory change resulted in about $1 trillion moving from prime to government money market funds, adding significant demand to the market for short-maturity government securities, including the RRP. For the month of November 2016, the daily RRP average fell to just $52 billion. It seems likely that higher T-bill yields enticed investors to move out of the RRP into T-bills or other similarly priced government securities, such as agency discount notes."
The monthly update also says, "The benign credit environment in risk assets has put the focus of prime funds squarely on the effects of Fed policy, especially with a sharply curtailed supply pipeline. Last month, we mentioned that we anticipated that LIBOR (London Interbank Offered Rate) would reset higher by about 2 basis points (bps; 100 bps equal 1.00%) a week as we approach the Federal Open Market Committee (FOMC) meeting in mid-December. And indeed, three-month LIBOR not only has methodically marched higher but also has exceeded our expectations, increasing 11 bps during November. At this pace, it may reach just under 1.55% at the time of the predicted 25-bp tightening at the December 14 Fed meeting. That may place three-month LIBOR just above the new upper band of the Fed target range of 1.25% to 1.50%. (Fed RRP is expected to be at the lower band of 1.25%.)"
Wells adds, "For prime money market funds, the gradual pace of Fed tightening has enabled managers of those assets to opportunistically extend weighted average maturities (WAMs) and weighted average lives (WALs) to take advantage of what yield pickup there is from extension out the curve. The average maturity for institutional prime funds has hovered in the mid-20s for the past several months. Our funds' WAMs have been slightly lower at around 20 days recently (with WALs closer to 55 days) in an effort to maintain increased amounts of liquidity and to be in a position to more quickly capture the effects of future rate hikes. In this environment, we continue to construct high-quality portfolios that are focused on liquidity while opportunistically purchasing floating-rate notes as we seek to incrementally increase yields."
Finally, the Bank of Japan mentions money funds and sources Crane Data in its latest "Financial Systems Report." (See page 45.) On the "Foreign currency funding environment," they comment, "In FX and currency swap markets, U.S. dollar funding premiums, which had been on an upward trend since around 2015, peaked at the end of 2016 and have declined since then (Chart II-2-2). Moreover, in the market for dollar-denominated CDs and CP, the issuance of those purchased by Prime money market funds (MMFs) had decreased substantially in the wake of the MMF reform in October 2016; however, the issuance environment has been improving as direct purchases by ultimate investors have gradually increased (Chart IV-3-7)."
The BOJ explains, "However, against the background of the difference in growth rates and yields between the Japanese and overseas economies, the appetite of Japanese financial institutions and institutional investors for investment in overseas assets remains strong. It is therefore likely that dollar funding premiums through FX and currency swaps will tend to experience upward pressure under a stress situation. Major banks, which have a wider range of dollar funding means, have accumulated client-related deposits in order to ensure dollar funding stability and have avoided utilizing comparatively expensive FX and currency swaps as a funding tool, especially since the start of 2017 (Chart IV-3-8). However, the amount of dollar funding through FX and currency swaps by Japanese financial institutions overall is still on an uptrend. This mainly reflects the increase in funding demand by regional banks and insurance companies, which do not have a wide range of options to secure dollar funding compared to major banks."
They add, "Meanwhile, the proportion of loans denominated in local currencies continues to increase, especially in the Asian region (Chart IV-3-9). While loan-to-deposit ratios have generally declined reflecting the fact that deposits have increased at a faster pace than loans, banks' dependence on market funding remains high in several currencies (Chart IV-3-10). Because liquidity in local currency funding markets is relatively low, financial institutions need to continue to make efforts to bolster stable funding bases through, for example, making committed lines with local banks and utilizing medium- and long-term funding means (swaps, capital, etc.)."
