The Fed’s balancing act
- The 25 basis point (bps) increase in the Federal Funds target range to 4.75%-5.00% will lift yields in Money Market Funds (MMFs) given their short duration profile and substantial positions held in overnight to one week maturities.
- Given the recent stress in the banking system, the Federal Reserve (Fed) has left the peak policy rate forecast for 2023 unchanged, acknowledging the need to balance financial stability with its dual mandate of price stability and full employment.
- The Federal Open Market Committee’s (FOMC’s) Summary of Economic Projections (SEP/”dots”) would seem to reinforce the view that we are approaching the end of the current tightening cycle. Managed Reserves portfolios have added high quality duration with this expectation in mind.
- Global Liquidity’s MMFs remain well-positioned to capture the uplift in overnight rates and are conservatively positioned with historically high levels of liquidity across the MMF platform.
March FOMC highlights
The FOMC maintained its firm stance against inflation by raising interest rates 25bps to 4.75%-5.00%, despite heightened financial stability risk. Interest on reserve balances (IORB) and the overnight reverse repo rate (RRP) were also increased by equivalent amounts to 4.9% and 4.8%, respectively.
The unanimous decision wasn’t without debate, as committee members weighed the impact of the recent banking sector challenges versus a continued strong labor market and sticky inflation. A pause was considered, but the FOMC believed that it was more important to use monetary policy action to address price stability and instead rely on other tools to keep financial stability in check.
The FOMC ultimately decided that a 25bps rate hike was appropriate. Notably, the committee adjusted its statement around the future policy path from "ongoing increases in the target range will be appropriate" to “some additional policy firming may be appropriate."
The last two weeks drastically changed the Fed’s future policy rate path, and the size of the hike was a little more than half of what was being priced in just prior to the closure of Silicon Valley Bank (SVB). According to Fed Chair Powell, it is believed that the recent tighter credit conditions are equivalent to one or more 25bp rate hikes, which is similar to what was ultimately priced out of the market for the March meeting.
On March 8, days prior to SVB’s closure, the market was pricing in about 43bps of hikes at the upcoming meeting with peak rates of about 5.69%. One week later, after the closure of SVB and Signature Bank and rising confidence issues in Credit Suisse, those expectations fell to about a 12bps hike for the March meeting, with peak rates falling to 4.52%. Since then, market expectations have moved higher with peak rates of about 4.93% as of March 22 and are relatively close to the Fed’s most recent 2023 year-end “dot plot” estimate of 5.125%.
However, the market and the Fed vary in their expectations for cuts this year. Immediately after the FOMC decision, the market had factored in nearly 63bps of cuts this year. By the end of the week, this expectation had risen to 88bps of cuts. The Fed, meanwhile, has no cuts factored into its base case scenario. Although the Fed continues to guide to a soft landing, the market believes that recent hikes may have gone too far when combined with the potential economic spillover from the banking issues. Nevertheless, it appears as if we are approaching the end of the current tightening cycle with perhaps one more 25bps hike in the future.
Exhibit 1: Fed fund futures implied overnight rate time series
Source: Bloomberg, as at March 22 2023.
The Fed made no adjustment to its balance sheet reduction, which continues to run in the background at a targeted pace of USD 95 billion a month (USD 60 billion in Treasuries and USD 35 billion in mortgages). Despite this ongoing reduction, the Fed's balance sheet has recently increased due to a rise in the usage of discount window borrowing by banks. The Fed believes that the market is not running into reserve shortages; rather, the increase was a direct result of heightened liquidity needs stemming from the recent banking sector challenges.
Implications for investors
We believe short-term cash investors should continue to welcome higher monetary policy rates and the Global Liquidity strategies remain well-positioned to capture the uplift in overnight rates and are conservatively positioned with historically high levels of liquidity across the various strategies.