The Federal Reserve is on the cusp of cutting rates. That much is crystal clear. When it does—most likely starting at its meeting September 18-–the yields on LGIPs and money funds will decline as well.   How far and how fast will they fall? Here is a perspective on that question: 

LGIP and money fund yields do not represent what an investor in the pool will actually earn.

We noted in the last Beyond the News issue that the industry standard seven-day yield is backward looking. It is not meant to represent the forward earnings rate on an investment, but it is often the only yield-related information available for an investor considering an LGIP. Money funds are required by the Securities and Exchange Commission to provide additional transparency (liquidity, weighted average maturity, underlying portfolio value) that adds context to the seven-day yield, and some LGIPs do as well, but most do not so investor knowledge about their portfolios is limited. This matters less In a stable rate environment when  the seven-day yield should closely track the dividend rate on a fund and  provide some (albeit imperfect) basis for comparing among pools or comparing pool yields with those of short term fixed rate investments (Treasury bills, commercial paper or bank CDs), but when short term rates change quickly—as when the Fed cuts—the seven day yield  is little help In this respect. 

Pool yields could fall by 15 to 20 basis points in the month following a 25-basis point cut.

 If the Fed cuts rates by one-quarter percent, we expect the dividend rate of stable value portfolios to average between 5.00% and 5.09% over the following 30 days. See the below table for details. But pool yields would likely experience subsequent  further decay.  At the end of the 30-day period one of our models showed a one-day yield of 4.84%--a much greater yield loss than might be implied by a single Fed cut of 25 basis points—and this would become the basis for the going-forward dividend rate in the post 30-day period. Thus a 25-basis point cut in Federal Funds could result in a pool’s yield dropping by 30-40 basis points over time. Why is this?

The cash market anticipates additional Fed cuts. This exposes pools to added yield declines in future months.

Our model portfolios would experience an additional yield loss of 15 to 20 basis points in future months because markets reflect the likelihood of additional declines in short-term rates. For example, at this writing the six-month Treasury bill has a yield of 4.65%. If the Fed cuts the Federal Funds rate by 25 basis points from its current 5.25% floor the Treasury bill would still have a yield  that is 35 basis points below the new Federal Funds rate.

The level of rates in the cash marketplace ultimately matters a lot. Investors do not stand still, awaiting Fed action, so rates reflect the (high) likelihood of multiple Fed cuts. It is not possible to “beat the clock” so to speak by locking in fixed rate investments for six or 12 months at a rate that is even with or ahead of current pool yields. That was a strategy that ran out of steam a couple of months ago.

Sooner or later pool yields will reach a new (lower) equilibrium point.

Pool managers face Hobson’s choice in managing the portfolio. A longer weighted average maturity may maintain a portion of the pre-cut income for longer but lose some short-term advantage. A barbell structure--with maturities clustered around near and more distant dates--will lose income more rapidly. This is seen by comparing the yields on the above table. In this cycle pool managers generally have opted for shorter weighted average maturities to maintain current yields up until the last minute. But those pools will lose yields more rapidly in the post-cut days.

What if the Fed cuts rates by 50 basis points?

You might think that the yield of a stable value pool would decline by twice as much by a given date (say 30 days post-cut) but that’s likely not the case.  Our model shows that a 50-basis point cut would lower pool yields by an additional 10-15 basis points over the 30-day period. To see this we compared portfolios with similar structures--in this case the 30 day WAM ladder structures in the above table. On day 30 the dividend rate of 4.78% compares with a rate of 4.92% where the Fed cuts only 25 basis points. Of course, over the long run all pool yields will reach a new equilibrium, but the yield of a pool with the longer WAM is buffered by securities held in the portfolio before the Fed moves.

Pools present some opportunities for arbitrage to gain added income.

All is not doom and gloom (lower rates) in a declining rate environment. Because pool yields lag the cash market, it should be possible to sell very short-term liquid investments and reinvest in a pool to gain additional income over the remaining term of the investment sold. This is because pool yields lag. Pools could also be a good temporary home for cash now parked at a bank if the bank is paying a rate that is tied to Federal Funds or otherwise adjusts the rate it is paying on deposits in response to the Fed’s cut.

Overnight repurchase agreement rates are likely to adjust lower immediately to respond to the Fed move and investors who rely on repo for liquidity could/should consider shifting funds to an LGIP or money fund because the current yield will likely take 30 days or more to adjust fully to a lowered Federal Funds rate.

Pool and money fund managers may limit access to these arbitrage opportunities, but past pool relationships could result in some accommodation. By using several large pools it could be possible to accommodate hundreds of millions of dollars.

Some state-sponsored pools offer stable value even though they have weighted average maturities that are much longer than the 60-day maximum permitted by the SEC and rating agencies for an AAA rating. For example, the California Local Agency Investment Fund has a WAM of about 210 days. Its yield, which is about 4.60%, has been relatively unattractive recently because its maturity meant it never adjusted completely to rising rates in the past two years. But expect the same on the way down:  a couple of Fed cuts and the LAIF pool yield could become very attractive, and the long WAM means that it will be slow to move lower.  State-sponsored LGIPs that are not managed to meet rating agency requirements—some would say they have the implied backing of stable value by the state—could become a favored investment vehicle in coming months.