In Brief

• The increase of 50 basis points (bps) in the Federal Funds target range to 4.25%-4.50% will lift yields in money market funds (MMFs), given their short-duration profile.

• The Federal Open Market Committee (FOMC) Summary of Economic Projections reflects a higher peak policy rate in 2023 than consensus expectations going into the meeting. The market continues to price cuts later in 2023, which may not be consistent with the FOMC’s message of higher for longer.

• The Federal Reserve (Fed) continues its balance sheet reduction with minimal impact on short-term markets to date.

• Our Global Liquidity portfolios are well positioned to capture the uplift in overnight rates and stand to benefit from continued tightening by the FOMC.

December FOMC highlights

The FOMC unanimously decided to downshift to a smaller but, in the words of Fed Chairman Jerome Powell, “still historically large increase” of 50 bps. The new target range is 4.25%-4.50%. Interest on reserve balances (IORB) and the overnight reverse repo rate (RRP) were also increased by equivalent amounts to 4.4% and 4.3%, respectively. While the slower pace could signal that we are approaching the end of this hiking cycle, the Fed has more work to do.

The Fed remains steadfastly committed to returning inflation to the 2% target, exemplified by the overall tone of the meeting, which leaned hawkish. A good visual example of the hawkish tilt can be seen in the FOMC’s Summary of Economic Projections (SEP) ”dots”. The “dots” are the Fed policymakers’ future estimates of the target rate and are released quarterly. This most recent estimate shows some material differences from September’s release. The median dot for the federal funds rate is now 5.125% in 2023, 50 bps higher, and 4.125% in 2024, 25 bps higher. However, what stands out is that 17 of the 19 FOMC participants expected a terminal rate of 5.125% or higher, with seven seeing rates at or above 5.375% in 2023. This is a significant shift, as no participants saw terminal rates higher than 5.00% in the last release.

Also notable is that the Fed is not pricing in any cuts in 2023. While this does not differ from the September release, the market has a more dovish expectation of a terminal rate of about 4.87% reached in May of 2023 and is pricing in about 50 bps of cuts next year. If we examine the Fed Fund futures implied overnight rates at the past few meetings, we see that cuts had previously been priced in by the market in 2023, but the magnitude of the cuts has grown more recently (Exhibit 1). This change is likely the result of the softer Consumer Price Index (CPI) print and the belief that the economy could be turning over faster than previously expected. Chairman Powell continues to stress that prematurely reducing rates carries risk. The Fed would prefer to assess the impact of recent policy actions and only cut rates when inflation is firmly under control.

Exhibit 1: Fed Fund Futures implied overnight rate time series

Source: Bloomberg. Data as of December 15, 2022.

The Fed’s balance sheet reduction, known as quantitative tightening (QT), continues in the background at a pace of USD 95 billion per month (USD 60 billion in Treasuries and USD 35 billion in mortgages) with minimal impact on short-term markets to date. Overnight rates continue to be anchored by a substantial amount of cash in the front end, illustrated by elevated RRP balances that remain above USD 2.1 trillion.

Implications for investors

We believe money market investors should continue to welcome higher monetary policy rates. The short average maturity of money market funds, due in part to the substantial positions held in overnight to one-week maturities, allows funds to quickly reset yields in line with market rates. As a result, Global Liquidity portfolios are well positioned to capture the uplift in overnight rates and stand to benefit from continued tightening by the FOMC.

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