Post Fed Hikes, All Short-End Yields Are Not Created Equal

The past few months have definitely been interesting times in financial markets, punctuated by the expected December rate hike by the Federal Reserve as well as the unexpected in politics.

We find cash investors still adjusting to the impact of money market reform, while longer-term investors are not only preparing for the prospect of higher rates, but desensitizing their portfolios to price volatility in order to avoid being shaken, if not stirred, by the markets at some point this year. “Safety first in ’17” has become a mantra du jour.

But yields on many of these traditional “safe” liquid assets are lagging the Fed’s hikes, putting traditional capital preservation strategies at an even more significant structural disadvantage during the course of 2017.

Little comfort from low yields

Almost religiously, many investors have once again pivoted to the old scriptures of safety by de-risking into traditional money market products and in particular government-only funds. These funds have already been bloated by money market reform, which resulted in assets increasing by approximately $1 trillion in 2016. Treasury bills, overnight repurchase agreements (repos) and regulated money market funds have been increasingly embraced as fears of the unknown and unexpected rate increases permeate investors’ psyches.

However, investors should take note of the low absolute yields which many of these “cash equivalent” assets offer, in both absolute and relative terms. Although the Federal Reserve has begun a journey toward higher rates beginning with December’s hike, some assets have not enjoyed the benefit of the march toward higher yields. Yields on T-bills, for example, are structurally subdued, with maturities less than three months trading below the lower rate threshold (the Fed’s reverse repurchase rate) of 0.5% established at the last meeting. Levels on repos have caught the bug as well (see chart), and have spent much of December and the beginning of the New Year at subdued levels quite below the market “risk-free” rate (i.e., the overnight index swap rate, or OIS).

49322-schneider-wittkop-blog-on-short-end-yields-chart

Consequently, government-only funds’ seven-day net yields have increased only 32 basis points (bps) to a 0.34% absolute yield since the Fed’s first rate hike on 16 December 2015, compared to a 50 bp move in the fed funds target rate. Furthermore, those same money funds’ net yields to investors increased only 11 basis points since the Fed’s second rate hike in December 2016. (All fund yield data from Crane Data LLC Money Fund Intelligence.)

Structural evolutions

Unlike in previous periods of rate hikes, strategies that embody T-bills and the like will continue to languish in their ability to recalibrate toward higher yields, as the Fed continues to move “risk-free” rates higher. Cash investors and long-term investors who are temporarily raising liquidity need to recognize this and be cognizant of the increased cost of employing these methodologies for capital preservation.

While T-bill yields are expected to remain structurally subdued even as the Fed continues its hiking process, other front-end rate benchmarks like Libor will move higher – three-month Libor recently passed 1% for the first time since 2009. Investors will become increasingly aware of this divergence and should consider strategies that can incorporate floating-rate assets into their compositions. As our colleagues have written in our economic outlook for 2017, we definitely see inflation heading higher.

As we’ve highlighted previously, this is one of the many structural evolutions occurring in front-end markets. A structural wedge is developing between traditional money market instruments and more dynamic liquidity management strategies. While nontraditional liquidity strategies may come with additional volatility, the opportunity cost of remaining in traditional strategies will only increase as the Fed continues to move rates higher, and the strategies’ structural failure to reward investors with higher rates becomes more evident.

Jerome Schneider is PIMCO’s head of short-term portfolio management and is a regular contributor to the PIMCO Blog. Andrew Wittkop is a PIMCO portfolio manager focusing on Treasury bonds, agencies and interest rate derivatives.

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