Cutting through the noise

Perhaps Bloomberg should create a Fickle Index. Or an Overreaction Indicator. VIX and MOVE capture volatility, but November brought yet another case of the capriciousness of the financial markets during this Federal Reserve tightening cycle. 

It seemed sanguine investors had finally capitulated in early fall after the Fed's September Summary of Economic Projections (SEP) showed an additional quarter-point hike by year-end and raised the median rate for 2024 (5.1%) and 2025 (3.9%). In October, gloom pervaded. A surge in long-term Treasury yields indicated markets felt that the Fed’s push to vanquish inflation would send the U.S. economy into recession.

Then came the November FOMC meeting, in which the policymakers again held the target range at 5.25-50%. Investors viewed this as dovish, even though Chair Jerome Powell stated they would not consider the rise in long-term yields a substitute for policy action. After further declines of the major measures of inflation, softening tone of some Fed speakers and deteriorating employment data, investors completed their sharp shift. Fed funds futures went from anticipating modest easing in 2024 to predicting four quarter-point cuts. Stocks and bonds rallied. Perhaps a Whiplash Index is also in order. 

We don’t think the about-face is justified. Again and again, policymakers have pushed back on wishful thinking. At the Jackson Hole symposium, Powell even took the time to squash the notion that they secretly adjusted their inflation target from 2% to 3%. The markets are hoping for a Grand Teton-like peak in rates; we think it will resemble Mesa Verde. So, we are positioning our portfolios for a higher-for-longer scenario, expecting a rate cut only in late 2024. The strength of the economy—recently the Commerce Department revised third-quarter GDP growth up to a robust 5.2%—supports that stance.

The November jobs report will be crucial. Not so much for the FOMC decision on Dec. 13, which will almost certainly result in no change, but for the updated SEP, which forecasts rates, GDP, labor and inflation. Our positioning will be based on that critical release, regardless of whether or not the markets ignore it.  

Let’s not forget that the ongoing reduction of the Fed’s balance sheet is contractionary. This consistent collateral, combined with the Treasury Department’s vast bill issuance of late, is offering cash managers attractive yields. And more of those securities are being traded via traditional counterparties rather than the Fed’s Overnight Reverse Repo Facility (RRP), whose use by the industry dropped under $1 trillion in November. The short-term funding system and investors benefit from this competition, with yields occasionally exceeding the RRP’s floor of 5.30%.

All told, the size of U.S. money market funds continued to grow last month. Industry fund assets vaulted over the $​6.​2 trillion bar for the first time ever in November, says Crane Data. All three sectors—government, prime and municipal—added net assets, led by retail products. With the Crane 100 Money Fund Index at 5.20%, it’s easy to see why. If the Fed does pause for most of 2024, the asset class should remain hard to beat.

Liquidity at large

Much like the Fed, the world’s major central banks seemed to have regained their footing in the fight against inflation. While they must consider Fed policy due to the dominance of the U.S. dollar and size of its economy policymakers have been addressing the particulars of their own country’s issues to good effect. That continued in November with the rest of the Big Four, which all held benchmark rates at current levels in October and November: Bank of England (BoE) at 5.25%, Bank of Japan (BoJ) at -0.1% and European Central Bank (ECB) at 4.0%. While the wars in Ukraine and Israel have a bigger economic impact on Europe than the U.S., the struggle to take inflation to around 2% is paramount. The OECD projects price pressures to force the BoE and ECB to keep rates at current levels until 2025. The BoJ also wants to see inflation at 2% (it is above that now), but for the opposite reason. Still fearful of a return of deflation, it is content to be dovish.

Liquidity products worldwide have benefited from the higher rates and the leadership of most central banks, including those of Canada and Australia, resulting in an adequate and stable supply of sovereign bonds. The large, high-quality corporate banks that comprise much of liquidity-product collateral have strong balance sheets, excess capital and hefty reserves. While flows to global money funds have not been as abundant as in the U.S., they are healthy.