Public treasury managers, get ready for interest rates take off
The stock and bond markets are all worried about “hitting it”: expectations that, over the next year, the Federal Reserve will cut back on the massive bond purchases it has made throughout the pandemic. More and more pros expect higher bond yields, which often deflate the market value of other financial assets. But that’s only half of what 2022 has in store. Once the Fed’s quantitative easing slows down, it’s only a matter of time before it has to start raising interest rates. short term.
These perspectives present a range of implications for public sector cash managers. These are the people who mainly focus on short term money market rates which include treasury bills, high quality commercial papers, federal agency and bank notes, market mutual funds. monetary and repurchase agreements (the latter with banks and bond brokers).
The cash reserves of their operating budgets cannot be risked in the price fluctuations of long-term bonds. Unlike the 1970s and 1980s, when inflation and Fed policy pushed short rates to high single digits and even double digits, and cash management produced a large chunk of operating budgets state and local governments, the near-zero interest rates of recent years have reduced the budgets of treasury departments because there is not enough return on the money invested to justify the personnel costs . As a result, many municipalities have outsourced their short-term investments to low-cost investment pools of state treasurers, money market mutual funds, and commercial fund managers, where economies of scale eliminate administrative and professional costs.
Meanwhile, U.S. government cash managers can’t really look overseas for advice on how to navigate this changing landscape. Unlike other G-7 central banks that have pushed their overnight interest rates to zero or lower, the U.S. Fed has kept its overnight rate at 25 basis points (1/4 of one percent). This policy was in part aimed at preserving the money market mutual fund and external cash management sectors by allowing overnight interest rates for consumers to remain positive after fees. For money market mutual funds, consumers are typically paid one basis point (0.01%) on their cash with the rest being consumed by fees, but this is not a negative number as it is. this is often the case in Europe, where savers actually have to pay fees to store their money. National government cash managers who invest directly in short-term securities can still earn a low but positive interest rate on their liquid assets.
Duration risk and opportunity costs
In a money market like today, the interest rate on investments is slightly higher on paper that matures later, like a year or two. It’s not much, but for some investors it’s better than nothing, and when interest rates fall aggressive cash managers have won by locking in those higher rates on longer maturities. But when inflation and interest rates rise thereafter, the reverse will be true: longer-dated investments may not offset rising rates and may even lose their principal value if sold on the market. free market to pay bills. The longer the maturity, the more market prices will fall. This is called “duration risk” – the threat of loss of capital when market rates rise. And even if investments are held to maturity, they incur opportunity costs: the loss of the ability to reinvest for a shorter term at higher rates. Both results are sub-optimal from the perspective of public sector budgets. This is where tapering comes in. term interest rates are rising and the central bank no longer feels obligated to provide accommodative monetary stimulus to the economy. What no one in the media is watching these days is the short end of the market. It is almost a given that short-term rates will stay near zero for many months to come, long after bond yields start to rise. Even the sophisticated financial futures market anticipates only minute changes in the short-term fed funds rate for at least a year.
Nonetheless, public cash managers would be wise to prepare for the possibility of at least one overnight interest rate hike by early 2022, as the Fed begins to tighten monetary policy. A small step of 1/4 percent wouldn’t bring the stock market down, but it would sober up some of the excess enthusiasm and risk appetite, and it would signal savers that they don’t need to. play with their money to earn at least a pittance on their capital. A slight rise would also send a powerful message to the forex markets, thereby strengthening the dollar, which helps to curb commodity inflation.
Thread the monetary stimulation needle
Historically, going back to the last century, it was more common for short-term interest rates to be closer to the rate of inflation than zero. Otherwise, savers are smarter to spend now before prices rise further, and such behavior fuels inflation. In 2022, it is now conceivable that the Fed will slowly but systematically start raising overnight silver rates in the short term. If inflation is still above 2% next year and short-term rates stay below the rate of inflation, as many expect (even including many Fed officials), savers and short-term investors will continue to lose their purchasing power. The Fed will therefore have to thread the needle by gently removing its monetary stimulus measures without scaring the bond and mortgage markets with sharp rate hikes that will stifle the nascent economic recovery. Fed governors prefer to function like an aircraft carrier, not like a ping-pong ball.
This is a reasonable baseline scenario. But while consumer price inflation and wage increases persistently exceed 3% by mid-2022, especially in light of rapidly rising rents and house prices, the money market and in particular 1- to 5-year bond rates will simply have no choice but to rise, lest bond vigilantes start to fear that the Fed has lost control. One way to think about this is that money market interest rates cannot stay indefinitely below the pace of wage increases paid to municipal workers, which reflect “core” inflation. If government wages start rising 3% per year in 2022, which I suspect they will, then money market rates below 1% could fuel inflation fears. This is a scenario for which prudent cash managers and public treasurers should be prepared and which those responsible for oversight should discuss with them.
My outlook represents a cautious contrarian view that is still early days, but I suspect it will be confirmed in capital markets next year. I have seen and planned this rodeo in previous decades. It was the kind of mid-cycle rate hike that caused the most infamous investment losses in municipal history.
It’s too early to start raising income from short-term investments in state and local budgets, but by next spring it’s probably a safe wait. In the meantime, public cash managers and those who oversee them should take a closer look at their portfolio structures and strategies to ensure that they do not indulge in overstretching their maturity scales. Don’t expect the sky to fall on the money markets until next year, but save some dry powder for the new year, when zero may no longer be the benchmark.
And think twice before holding bond maturities that extend beyond 2022 for operating funds and cash reserves. No one wants to repeat the infamous local government investment losses of 1984 and 1993, when cyclical interest rate spikes blew up the risky portfolios of two treasurers as the US economy shifted into high gear. As traders say, it is reckless to pick up pennies before a steamroller by hitting riskier, riskier maturities to seek a tiny yield advantage today.
Governors opinion columns reflect the opinions of their authors and not necessarily those of the editors or management of Governors. Nothing herein should be construed as investment advice to buy, sell or hold any specific security. Public investors should consult with their advisers and those responsible for overseeing prudent strategies.