Uncertainty Rises Over Short-Term Interest Rate Outlook, U.S. Money Market Funds Accelerate Allocation to Ultra-Short-Term Assets

According to Zhitong Finance APP, as uncertainty over the Federal Reserve's policy path and short-term interest rate outlook intensifies, U.S. money market funds are further reducing interest rate risk by accelerating allocations to ultra-short-term assets, aiming to retain flexibility for reinvesting at higher yields in the future.

Crane Data shows that the weighted average maturity of money market fund holdings has dropped from 45 days in mid-May to 40 days currently. Fund managers are allocating more capital to overnight repurchase agreements, short-term securities, and floating-rate U.S. Treasuries and agency bonds, while the allocation to U.S. Treasury bills has decreased, despite the Treasury Department’s ongoing expansion of short-term debt issuance.

Recently, a rise in international oil prices and relatively hawkish remarks by Federal Reserve Chair Waller led to market bets that the Fed could raise rates as soon as this month. However, the two moderate inflation reports released last week made the policy outlook murky again, prompting investors to readjust their rate expectations.

Against this backdrop, U.S. money market funds with assets under management exceeding $8 trillion are more inclined to allocate to assets maturing within weeks, rolling over, or with rates that can reset quickly so that funds can be reallocated to higher-yielding products promptly if rates rise again.

Deborah Cunningham, Chief Investment Officer of Global Liquidity Markets at Federated Hermes, said: “Investors want to keep enough ‘ammunition’ to capture better investment opportunities in the future, and so will appropriately shorten the weighted average maturity of their portfolios.”

Market participants noted that fund managers want to avoid a repeat of early 2022, when some institutions held longer-term assets and the Fed subsequently began one of the fastest hiking cycles in decades, exposing portfolios to considerable interest rate risk. That experience has made managers more cautious amid the current policy uncertainty.

Geoff Gibbs, Managing Director at DWS Group, said at the Crane Money Fund Symposium last month that the company has allocated about half of its portfolio to repurchase agreements since the start of the year and is expected to maintain this strategy, especially after markets have repriced in rate hike expectations.

Data shows that in June this year, U.S. money market funds increased their allocation to repurchase agreements by about $36 billion, bringing the total to approximately $1.89 trillion.

At the same time, funds have continued to increase allocations to floating-rate bonds. Wells Fargo strategists Angelo Manolatos and Francis Brown noted that in June, the holdings of U.S. Treasury floating-rate bonds rose to a record $523 billion, reflecting managers' desire to lock in higher yields on three-month Treasury bills while avoiding lengthening portfolio duration.

Additionally, FHLB financing data show that since the beginning of the year, outstanding FHLB bonds have increased by about $180 billion, with around $140 billion of that being newly issued floating-rate bonds. Over the same period, total institutional bond holdings in money market funds increased by about $195 billion. By comparison, even as the U.S. government continues to ramp up short-term Treasury issuance, money market fund holdings of U.S. Treasury bills declined by nearly $105 billion last month.

Cunningham expects that as the Fed continues to focus on bringing inflation back to target, the average duration of money market funds will continue to shorten.

Manolatos noted that a rate hike in September is still possible, and with several Fed officials continuing to send hawkish signals, money market funds are expected to continue gradually shortening their portfolio maturities. “For fund managers, unless there’s a compelling reason, the preference is to allocate new capital to repurchase agreements or floating-rate bonds, rather than take on additional duration risk.”