The big market news last week was a strong rally that pushed most interest rates down by 30-40 basis points. To see what it meant for public fund investors, check out the updated Dashboard.
Here are highlights:
● The market rally, which pushed down interest rates of most tenors by about 30 basis points, was fueled by results of a meeting of the Federal Open Market Committee and follow-on comments by chair Jerome Powell. Investors, already primed for the central bank to signal a move to lower interest rates in coming months, concluded that significant cuts in rates would begin early in 2024 and that by January 2025 the Federal Funds rate would be about 3.75%. That is what the price of federal funds futures contracts implied by the end of the week. (A caveat here: Fed funds futures levels were notoriously bad in forecasting the path of rates during the current hiking cycle, but. . ..)
● While the strong bond moves and accompanying stock market move grabbed headlines, in reality this was a continuation of a two-month trend that saw most rates decline by 80-90 basis points since their October peaks. We posed the “go long?” proposition in our Beyond the News issue November 2.
See the following chart of the yield on the two-year Treasury note this year:
Source: Bloomberg LP
(Side note: Has this been a roller coaster year or what?)
Of course, the Fed has not (yet?) cut rates. Thus short-maturity securities barely reacted to the euphoria. The three-month Treasury Bill, for example, was unchanged in the week, with a yield of 5.37%. So (obviously) whether and how much the rally affected a portfolio depends on its maturity.
LGIP and money fund yields were hardly affected, but. . . The PFII LGIP net yields indices were virtually unchanged week over week: 5.54% for prime LGIPs, and 5.32% for government-centered funds. This is because on average stable value LGIP portfolios were invested for 35-45 days as of December 1 and because ultra-short rates like the rate on overnight repurchase agreements were not affected by the broad rally. That said, LGIP rates could drift lower by five-10 basis points over the next month or two.
That is because their yields are supported by longer-maturity holdings that will eventually mature and the yield of replacement securities is currently lower than it was a month or two ago. This is especially true for prime LGIPs, where managers who extended maturities in September/October could buy 9–12-month commercial paper and bank deposits at close to 6%. They would receive only 5.25%-5.30% now.
Money market fund yields behaved similarly, though the net yields of the PFII money market fund indices remain a bit lower than those of LGIPS.
LGIP and money market fund portfolios were positioned well to respond to the rally. The Dashboard shows that managers had been extending maturities since late Spring, positioning portfolios on the assumption that the Fed had neared the upper terminal rate of its tightening program. In recent weeks, the move to lengthen portfolios accelerated (see the following chart), so that by early December the weighted average maturities were 44 days for government portfolios and 35 days for prime LGIPs
Given that the maximum WAM permitted for 2a-7 funds and by the ratings agencies for a top rating is 60 days, the portfolios were positioned at a slightly bullish position, slightly longer than 30 days. Money fund managers made the same moves.
After the central bank made its final move to raise the bank rate to 5.50%, one year Treasury bill yields peaked at 5.55% in late September and yields of long-tenor credit instruments approached 6%, providing a reward to those who extended. By the end of last week, the one-year Treasury bill yield was 5.00%. So, the current market really does not support additional extensions—unless one believes the overnight bank rate is going to fall imminently.
We will see.
Separately managed portfolios benefited from the rally but. . .. The rally last week boosted returns of separately managed portfolios, with greater benefits accruing to those with longer durations. The 1–3-year portfolio we model (60% Treasuries, 30% investment grade credit, 10% cash) returned 0.67% for the first half of December. That is an annualized rate of more than 16%! Even better than the 13.99% annualized return for November. But even with these two stellar periods, returns for money invested in a prime LGIP for the year were ahead of returns for the 1–3-year model by more than one percent.
Cash is still king, but the difference has narrowed and would be reversed if indeed the Fed undertakes an aggressive rate cutting strategy early in 2024.
Meanwhile the rally reduced the income potential of longer-tenor securities. As recently as five weeks ago two-year Treasury yields were above 5.00%; they closed last week at 4.44%. Investment grade corporate bond yields fell even more, as spreads to Treasuries also narrowed.
Still today’s rates--5.00% for one-year Treasuries, 4.00% for those with a five-year maturity—with an added 50 to 75 basis points for taking on corporate credit risk—are near 15-year highs and, at least where Treasuries are concerned, can be counted on to pay a steady income stream for their life