Economic Overview

“Uncertainty” has been the investment “word of the year” so far, driven by several key factors:

Federal Reserve Policy: Forward markets currently expect the Federal Reserve to cut rates one to two times by year-end, with further cuts priced in next year, placing the overnight rate below 3.5% by the end of 2026. Since April, expectations for Fed cuts have been volatile, with as many as four rate cuts priced in for 2025 when tariffs were initially announced. The Fed's decision to pause after 100 basis points of cuts in 2024 reflects a cautious approach to balancing inflation control with economic growth and the health of the labor market. The geopolitical situation, which includes a component of potential energy market volatility, makes the Fed's task more challenging. Broadly, the US economy has shown substantial resilience in the face of 4%+ interest rates, with softer survey data not yet manifesting itself in the hard data.

Debt Ceiling Resolution: The recent increase in the debt ceiling (by $5 trillion) via the "One Big Beautiful Bill" (OBBB), provides temporary relief, but highlights ongoing US fiscal challenges. The Congressional Budget Office (CBO) projects a federal budget deficit of $1.9 trillion for fiscal year 2025, which indicates that this temporary fix postpones another debt ceiling episode for approximately two years, similar to the resolution in 2023. The fact that the debt ceiling will be revisited again in the relative near-term, coupled with the absence of material deficit reduction in OBBB, leaves a shadow of fiscal uncertainty hanging over the US Treasury market for the foreseeable future. In a silver lining for front-end investors, the Treasury's plan to rebuild its cash balance is expected to lead to higher Tbill and repo rates for the balance of the year.

Tariffs and Inflation: Tariffs remain at historically elevated levels, contributing to inflationary pressures and impacting consumer purchasing power. The Fed's cautious approach reflects the need to balance inflation control with economic growth and labor market stability. Tariffs are expected to slow consumer activity over time and create inflationary pressures, with the geopolitical situation further complicating the economic outlook. With the ultimate timing and magnitude of US tariff policy remaining in flux until at least August 1, the degree of pass-through to inflation and the duration of any pass through to prices in the US remains an open question – and arguably the most challenging element of the current investment environment. The US CPI report for June showed underlying signs of tariff pressure on goods markets, and could be the first in a series of reports that cloud the inflation outlook for the Fed and market participants.

Investment Strategy

In this environment, several investment implications are relevant for cash investors:

Duration Management: Though the timing and extent of easing is still unclear, interest rates are expected to decline into 2026. Therefore, we think extending duration in the short-end of the yield curve to lock in today’s cash rates is a prudent strategy for the balance of the year. This is an approach we will continue to deploy in our product offerings to maintain and protect yield, but investors can also take steps to optimize duration opportunities by considering ultra-short fixed income as an asset class to complement daily-liquidity management vehicles like money market funds (MMFs).

Diversification and Liquidity: A diverse portfolio with exposure to different sectors and credit ratings can enhance portfolio stability and liquidity in uncertain markets. For example, working closely with our in-house credit research analysts to understand sector-specific tariff impacts has helped guide our recent investment decisions. Cash investors can similarly structure their investment policies to allow for sector and credit rating flexibility which adds more optionality in uncertain markets. Money market funds and ultra-short fixed income portfolios provide a balance of yield and capital gain potential, allowing investors to navigate the current environment with confidence. Our emphasis on core investment principles of liquidity and principal stability remains unchanged, but flexibility to adapt to evolving market conditions is important.

Opportunistic Positioning: The anticipated increase in Tbill supply following the debt ceiling resolution presents opportunities for strategic positioning in short Tbills, which are expected to experience relative cheapening. The Treasury's plan to increase auction sizes in the short-end of the curve aligns with historical patterns, providing opportunities for investors to capitalize on relative value. In addition, the recent evolution of rate cut expectations has created opportunities in Tbills with maturities in Q425 and beyond, offering protection against potential rate cuts. The increased Tbill supply is also likely to pressure repo rates higher, favoring a barbell strategy, for funds and accounts that can lend cash vs UST collateral.

Conclusion

As we navigate the remainder of 2025, money market fund investors should remain flexible. The combination of fiscal policy changes, expected monetary easing, and geopolitical tensions requires a strategic approach to portfolio management. By focusing on duration management, diversification, and opportunistic positioning, investors can effectively navigate the current landscape and seize yield opportunities. The persistent volatility and uncertainty underscore the importance of active management and a focus on core investment principles.