MMF investors should prepare for the Federal Reserve to ease interest rates at the September Federal Open Market Committee (FOMC) meeting, now that inflation has been tamed. Rate cuts were predicted much earlier in 2024, but the market had to reprice because of enduringly high first quarter inflation readings.
“Inflation was proving persistent and tricky to combat,” said Pat O’Callaghan, Global Head-Client Portfolio Management, Liquidity Solutions at Goldman Sachs Asset Management.
He said the trend of lower core inflation is here to stay and that policy makers are concerned by the uptick in unemployment which he attributed to immigration rather than layoffs. O’Callaghan predicted a series of 25 basis point rate cuts that will see a total 75 basis point cut by the end of the year.
O’Callaghan said assets in global MMFs had reached record levels and one of the key drivers has been the expectation that the Fed would start to lower rates. Because MMF yields lag market rates, they have provided a better yield than many other securities. “MMF yields have remained high across various fund types,” he said. However, he warned these yields would start to move lower once the Fed begins easing although the impact would be cushioned by diversification.
“MMFs will continue to be attractive assets for clients with short-term cash needs compared to other investments that are more correlated to what the Fed is doing.”
He said appetite for MMF has also been driven by investors seeking a safe haven from the volatility and stress caused by the regional banking crisis when treasury teams “moved out of balance sheet” and into MMF assets.
O’Callaghan said that anticipation of lower rates is triggering a number of strategies. For example, investors are switching from reverse repo into non-Fed counterparty reverse repo facilities – choosing to use a different counterparty for their repo allocation and not rely so heavily on the Fed. “The rates in non-Fed reverse repo eclipse what the Fed offers through reverse repo,” he said.
In another trend, he noticed MMF investors are moving funds out of reverse repo into the direct treasury bucket. Government treasury MMFs offer the best liquidity and enable treasury teams to invest across various terms depending on their views of Fed policy relative to market pricing.
He said investors are steadily increasing allocations to longer dated trades and opting for a more granular bucket on where to deploy capital as they prepare for lower market interest rates and the next phase of the market cycle.
O’Callaghan also flagged the implications of the next wave of MMF reform. Staggered reforms were introduced in the wake of Covid-induced volatility in MMFs that saw stress in the short-term funding markets and significant redemptions of Prime Fund assets.
In the first wave, gating provisions were removed in October 2023, followed by new rules in April 2024 that set a higher level of liquidity on an overnight and weekly basis. This October, new rules state that when a fund experiences total daily net redemptions of 5% or more of its net assets in a single day, then it must calculate the cost of selling a vertical slice of the portfolio raising uncertainties around redemptions, fees and costs for investors.
The rules are meant to protect existing shareholders at times of stress and volatility, but O’Callaghan said they have introduced a higher cost to institutional prime funds compared to government treasury funds. He said the new rules have decreased the utility of institutional prime funds which has resulted in fund managers closing institutional prime funds.
