Coming to terms
Investors have begrudgingly capitulated to a still-hawkish Fed.
Acceptance is hard, and the financial markets have struggled with it this year. Investors turned relief about moderating inflation and a slowing pace of Federal Reserve rate hikes into the expectation that the conclusion of the tightening cycle is imminent. Stocks and bonds rallied further when the January Federal Open Market Committee meeting resulted in an even lower hike, with the Treasury yield curve indicating policymakers would cut rates in the fourth quarter.
We didn’t buy this narrative. The markets crossed the fine line between expectations and wishful thinking. But investors checked that fantasy within the shortest month of the year. Indeed, change can come quickly after acceptance. In addition to a correction in equities and fixed-income, the yield curve shifted upward in February to reflect the likelihood the Fed will take the fed funds rate higher and hold it there at least into 2024. The change is corroborated by futures trading that places the terminal rate in the 5.25-5.5% range.
Recent inflation data supports this reality check. The rule of thumb is to pay attention to the core version of price measurements because they exclude the short-term fluctuations of energy and food costs. But it’s also better to focus on month-over-month (m/m) changes rather than year-over-year. The latter can be misleading, especially when the previous year’s figures are substantially different—the so-called base-effect phenomenon.
Case in point, the annualized core Consumer Price Index slipped from 5.7% in December to 5.6% in January, but rose 0.4% m/m. While annualized core Personal Consumption Expenditures Index (PCE) rose from 4.6% in December to 4.7% in January, it climbed 0.6% m/m.
The takeaway here is that the descent from a peak is often faster than the rest of the downward journey. If you listened to Fed Chair Jerome Powell’s comments in the press conference following the January FOMC meeting, you heard him reiterate that policymakers pay close attention to “core PCE services ex-housing.” They consider it an excellent judge of price pressures because the housing market reacts much quicker to shifts in rates than the rest of the economy. The bad news is that it has accelerated lately, jumping 0.6% m/m in January. Inflation is proving sticky once again.
The rightsizing of market expectations has given us the confidence that yields offered on government and corporate securities maturing in the second half of 2023 won’t be underwater. We shifted the weighted average maturity (WAM) of our prime money market funds out by five days. Not a big move, but it’s more than symbolic.
We’d probably be more aggressive were it not for the debt ceiling fiasco. We haven’t changed our opinion that it will be resolved in some form, most likely with another kick of the proverbial can. But we think the supply of Treasury bills will dwindle as we get close to the X-date this summer, reversing the trend of the last few months, and that securities maturing near it will be cheap.
But the big picture is that we expect yields of liquidity products to keep climbing. And so do investors. In money fund land, strong returns are keeping industry assets at record highs. While that is led by retail investors, high-net-worth customers are leaving bank deposit products due to comparably paltry interest rates, according to the Wall Street Journal. The liquidity industry is certainly happy to accept those.
Our WAM targets are now in a range of 20-30 days for prime money funds, with our government and municipal products remaining in a slightly longer range of 25-35 days.