In Brief

• The 75 basis point (bps) increase in the Federal Funds target range to 3.75%-4.00% will likely lift yields in Money Market Funds (MMFs) given their short duration profile and substantial positions held in overnight to one week maturities.
  
  
• The Federal Open Market Committee’s (FOMC) updated statement has shifted market focus to monetary policy lag effects, and the possibility of slowing the pace of future rates hikes. However, it acknowledged the peak rate may need to be higher and stay there longer.
  
  
• The Federal Reserve’s (the Fed’s) balance sheet reduction continues in the background with, in our view, no near-term material impact on short term credit markets. Reserve levels remain adequate with a substantial amount of cash in the front end, illustrated by elevated Fed reverse repo (RRP) balances above USD2.2 trillion.
  
  
• Global Liquidity portfolios seem well-positioned to capture the uplift in overnight rates and stand to benefit from continued tightening by the FOMC.
  
  

November FOMC highlights

The FOMC showed once again that it is prepared to take interest rates into sufficiently restrictive territory in order to clamp down on inflation. For the fourth consecutive meeting, it unanimously decided to increase its Federal Funds target rate by 75bps to a range of 3.75%-4.00%. Interest on reserve balances (IORB) and the overnight RRP were also increased by equivalent amounts to 3.80% and 3.90%, respectively.

It seemed the Fed had initially guided the market to a potentially slower pace of future rate hikes. In the statement, the committee shared that it “will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation and economic and financial developments.” This was an update to the September statement and while we assume the Fed was aware of this dynamic, the fact that it was highlighted in the statement signaled that perhaps we are nearing a slowdown in the pace of rate hikes. The markets initially took this as dovish and if the Fed left the communication without any follow up commentary, it could have eventually been perceived as a stumble in the central bank’s inflation fight. This could have potentially led to a rise in inflation expectations, which we know is harder to get back under control once entrenched.

At the conference, Chair Powell’s comments leaned more hawkish. He stated that it would be “very premature” to think about pausing, that the costs of under-tightening are greater than the costs of over-tightening, and that the data since the last meeting suggests that interest rates will be higher than previously expected. At the time of the September meeting, the median FOMC terminal rate expectation was 4.625% for this cycle. Post-conference, market expectations for the terminal rate slightly rose and remain north of 5.00%, while the timing of when we will reach the terminal rate was pushed out a meeting to June 2023. Also, some of the rate cuts that were priced into the market for the latter half of 2023 began to get priced out. Ultimately, the Fed has seemingly taken the focus off the road and centered it on the destination, thus potentially pivoting to a slower pace of rate hikes while appearing steadfast in its inflation fight.

The chart below (Figure 1) is a good visualization of how the Fed was able to communicate a potential downshift in the pace of rate hikes, while market perception of Fed hawkishness continues to strengthen.

Figure 1: Fed fund futures implied overnight rate time series

Source: Bloomberg, as at November 3 2022.

The Fed’s balance sheet reduction (quantitative tightening) continues in the background at a pace of USD95 billion a month (USD60 billion in Treasuries and USD35 billion in mortgages). We anticipate the current pace will have no near-term, material impact on short-term credit markets as demand for short-dated investments remains high, illustrated by elevated Fed RRP balances above USD2.2 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 seem well positioned to capture the uplift in overnight rates and stand to benefit from continued tightening by the FOMC.

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