For the last few years, money market funds (MMFs) have existed in a low interest rate environment. Alongside compressed yields, the recent landscape has also been characterised by a mismatch in supply and demand. “We’ve been at zero or negative interest rates, but the available supply has been diminished,” explains Laurie Brignac, Head of Global Liquidity at Invesco. “Usually you would expect that low rates may encourage people to leave money market funds– but we haven’t really seen that.”
In fact, as Paul Mueller, Head of Global Liquidity EMEA Portfolios at Invesco, points out, the AAA-rated MMF market for GBP has grown six-fold since 2004, while the EUR market has almost quadrupled in the same period – “despite rates being negative since 20141.” While some clients have looked at setting up segregated mandates, or investing in MMFs to squeeze out more returns, Mueller says there have not been material flows into these areas – not least because the volatility brought by the pandemic may have deterred people from taking additional risk.
Interest rate outlook
While the last decade has been characterised by low rates, it’s clear that the landscape is now changing. Where GBP is concerned, the Bank of England was gauging the possible impact of negative interest rates little more than a year ago – but with inflation concerns taking centre stage, a rate hike in December 2021 was followed by another in February. Further increases are expected: Mueller notes that the market is now pricing in rate hikes of around 1.75% by the first quarter of 2023.
Turning to the US, meanwhile, last year’s ‘Powell pivot’ gave rise to expectations of two rate hikes this year – “and now we’re pricing in over five, with some dealers calling for seven rate hikes,” says Brignac. She adds, “Looking at the next Fed meeting, we’re pricing in a strong possibility of two rate hikes in March. But there’s a strong possibility that the market is overpricing how aggressive the Fed is going to be, which makes it quite interesting for our clients.”
Until recently, interest rates in Europe had not been expected to move in 2022. As such, Mueller notes that the ECB’s recent comments about near-term risk to inflation “have opened the floodgates to the market to start pricing in quite a rapid turnaround in interest rates in Europe, which to us certainly seems a bit premature.” He points out that the ECB has previously stated it would need to finish asset purchases before starting to make rate hikes. “So if they’re going to price an increase in Q3, they’re going to have to bring that much sooner forward.”
Impact on MMFs
With interest rates set to increase in the coming months, what could a rising rate environment mean for MMF providers? In today’s unusual market conditions, this question may be difficult to answer. As a heavily regulated investment vehicle, a significant portion of any MMF portfolio will always be in overnight to one-week paper. “Apart from that, it’s really going to depend on how quickly central banks may be raising rates,” comments Brignac. “As we’re looking at that, liquidity always comes first. The second question is, where is the value up the curve? Does it make sense to extend out?”
Where floating rate instruments are concerned, Brignac notes that as rates go up, securities will start to reflect the higher interest rates – sometimes even ahead of the move. “One of the best indices for that was always LIBOR, but a lot of the indices that we are now looking at or referencing are overnight, so they don’t necessarily reflect higher interest rates until the central banks actually move,” she says. “This is another reason why these hiking cycles are different to what we’ve seen before.”
Traditionally, says Mueller, “you’ll see an immediate drawdown in money market fund assets in a rising rate environment – but after one or two hikes, we may start to get more money coming in, because investors will look to park their cash on the front end until the central banks have finished raising rates. So we may see inflows at some point during the hiking cycle.”
Of course, rising rates are not the only factor set to impact MMFs in the coming months. The COVID-19 crisis has also prompted regulators to look once again at money market fund reform, as part of a wider conversation about liquidity across different markets. “There are quite a few moving parts in today’s market,” concludes Brignac. “People need to be quite diligent, and work with their partners to understand what these developments could mean.”