FOMC decision and money market impact

The Federal Open Market Committee (FOMC) has taken the first step in easing monetary policy with a long-anticipated 50 basis points (bps) interest rate cut, taking the federal funds target rate down to 4.75%-5.00%. The reduction is the first adjustment to the Federal Reserve’s (the Fed’s) policy stance in over a year and marks the first rate cut since the Fed reduced rates by 100bps at the start of the Covid pandemic, in March 2020. Interest on reserve balances (IORB) and the overnight reverse repurchase agreement (repo) rate were also reduced by 50bps to 4.9% and 4.8% respectively. Additionally, the Fed’s quantitative tightening (QT) program was left unchanged with no immediate impact to market liquidity, with Reverse Repurchase Program (RRP) operations remaining an outlet for Fed balance sheet adjustments.

While the FOMC’s decision to lower the target rate will directly impact money markets, reducing overnight rates by about 50bps, markets have been pricing in rate cuts through lower yields across the money market curve for some time. The pass-through of monetary policy in money market funds (MMFs) is high, driven by high liquidity mandates. Recent US reforms require MMFs to hold at least 25% in daily liquid assets and 50% in weekly liquid assets, with fund liquidity typically surpassing these thresholds. Much of this portion of the portfolios will reset within one day to one week, including any floating rate positions pegged to an overnight index like the Secured Overnight Financing Rate (SOFR). Consequently, MMF yields will decrease following the Fed’s decision.

However, for most of the year, MMFs have continued to seek opportunities to incrementally add fixed-rate duration and lock in higher yields, delaying the full pass-through of lower monetary rates. This extension is evident in the weighted average maturities (WAMs) of the funds across the industry, which have generally increased year over year since the last rate hike in July 2023. A fund’s WAM reflects the portfolio’s average time to reset, and is a good indicator of how long it will take for the portfolio’s positions to reflect a new rate environment. This WAM extension typically leads to a slower pass-through of lower rates in MMFs compared to other market-based liquidity products (for example, bank deposits and U.S. Treasury Bills) and has historically let to increased usage of MMFs in the initial stages of easier monetary policy.

Projections and quantitative tightening

The FOMC also released its quarterly Summary of Economic Projections (SEP/”dots”), which plot the future estimates by Fed policymakers for the economy and the target rate. The 2024 and 2025 dots were revised 75bps lower from their June estimate to 4.375% and 3.375%, respectively. The projections reflect Fed chair Jerome Powell’s belief that inflation is coming down, and while employment is relatively weaker the labor market is in a good place. Consequently, the 50bps pace of rate cuts is not expected to continue. 

Additionally, the long-run rate was increased from 2.75% to 2.875%. Although the rate remains low relative to some estimates that suggest a terminal rate north of 3%, the range of estimates is still well above the zero lower bound policy range we grew accustomed to during the 2008-2020 period and would leave a sufficient level of return for money market investors.

The Fed's QT program, meanwhile, remains unchanged, with no immediate impact on market liquidity. The runoff pace is capped at $25 billion in Treasuries and $35 billion in agency mortgages per month. Since the start of QT, the market has questioned when reserves will transition from “abundant” to “ample” to “tight”, and when reserve tightness might be reached.

The Fed’s balance sheet has shrunk by about $1.7 trillion from a peak of $8.8 trillion two years ago, shortening the runway to reserve tightness. As the Fed’s assets shrink due to QT, so too will its liabilities. So far, the RRP facility has been the primary outlet for balance sheet contraction, absorbing nearly the entire decrease. However, with only about $300 billion of the RRP remaining, it cannot fully absorb further reductions for much longer, and reserves will need to adjust.

If reserves become too tight, we could see a surge in overnight rates, similar to what occurred in the fall of 2019. It appears as if remaining RRP balances are likely to decrease more slowly due to the potential intraday liquidity benefits of repos to MMFs, and because of repo counterparty diversification limits, which constrain how much cash can move away from the RRP. Overall, QT has not yet significantly impacted the money market space, and it appears there is still some runway before reserve tightness is reached.

Implication for investors

Global Liquidity’s suite of USD MMFs are well-positioned for a declining rate environment, as WAM extensions will delay the full impact of lower overnight rates. QT has yet to affect our space and, if anything, should bias short-term rates higher within the federal funds target range. Looking ahead, MMFs will continue to position WAMs for easier monetary policy, and investors could benefit from a slower pass-through of lower rates in MMFs compared to other liquidity management products that are more rapidly impacted by changes in overnight rates.

Global Liquidity's Ultra Short Duration funds have prepared for interest rate cuts by adding fixed rate instruments in the 1-3 year part of the curve and selling some of the longer floating rate instruments. These trades will benefit as the Fed follows through on its recalibration of interest rates lower.