Cash yields have risen along with rates, which may help investors reduce duration risk
By Rob Corner, Senior Client Portfolio Manager. Posted on Expert Investment Views: Invesco US Blog.
US money market fund balances recently reached their highest level in seven years1 and, according to Crane Data, average money market fund yields crossed the 1% threshold for the first time since November 2008.2 Invesco Global Liquidity believes that more investors may consider cash and conservative fixed income solutions as part of their active asset allocation in the near term for multiple reasons.
Cash yields rise due to Fed rate-hiking cycle
Yields on cash and conservative low duration vehicles have become more attractive since the US Federal Reserve (Fed) began removing monetary policy accommodation and moved away from a near-zero Federal Funds rate. Since December 2015, this policy shift has driven the Federal Funds rate higher by 125 basis points.3
As the Fed continues to push the Federal Funds rate higher, we expect yields on US money market funds and other cash and conservative low duration vehicles to become even more attractive on a relative basis. Recent history has shown that the US Treasury yield curve tends to flatten during Fed hiking cycles, meaning that shorter-term yields rise faster than longer-term yields (Figure 1).
Figure 1: When the Fed has hiked rates, the yield curve has flattened
Sources: Invesco, Bloomberg L.P., US Federal Reserve, data from March 31, 1983, to Jan. 31, 2018. The current cycle is measured from Nov. 30, 2015, to Jan. 31, 2018. The prior five cycles are measured from 1) May 31, 2004, to June 30, 2006, 2) May 31, 1999, to May 31, 2000, 3) Jan. 31, 1994, to Feb. 28, 1995, 4) Nov. 28, 1986, to Feb. 28, 1989, and 5) March 31, 1983, to Aug. 31, 1984. The starting date is the month-end date prior to first rate hike; the ending date is the month-end date of last cycle rate hike; current cycle end-date is the latest month-end. Past performance is not a guarantee of future results.
In fact, a flattening of the yield curve has been underway since the Fed initiated its current rate-hiking cycle late in 2015. From Nov. 30, 2015, to Jan. 31, 2018, the yield on the two-year US Treasury note jumped 121 basis points, to 2.14%, while the yield on the 10-year US Treasury note increased by a lesser extent, rising only 50 basis points to 2.71%.4
Looking forward, we believe the likelihood of further Fed rate hikes is high. First, the Fed's latest summary of economic projections, also known as the "dot plot," pointed to expectations of three rate hikes in 2018 and more hikes in 2019.5 Second, combined rate increases in the current Fed hiking cycle total less than half the historical average of 322 basis points, and could have more room to run (Figure 1). Based on history, we expect further Fed rate hikes to lead to potentially more attractive cash yields and further flattening of the yield curve.
Historically cash has outperformed short-term and intermediate fixed income during Fed hiking cycles
Invesco Global Liquidity believes cash and conservative low duration vehicles could outperform short-term and intermediate fixed income strategies during the current Fed hiking cycle. In each of the last five Fed tightening cycles, the three-month US Treasury bill index outperformed 1-3 year, 1-5 year, and 1-10 year government and credit indices.6 The average of this relative outperformance ranged from just over 100 basis points, annualized, versus the 1-3 year index, to more than 200 basis points, annualized, versus the 1-10 year index (Figure 2).
In this environment, we believe an active allocation to cash and conservative low duration strategies may be considered by investors as a method to help reduce overall fixed income duration risk.
Figure 2: Rate hikes have led to outperformance by three-month Treasury bills
Source: Invesco, Bloomberg LP, Citi, data from March 31, 1983, to June 30, 2006. The prior five cycles are measured from 1) May 31, 2004, to June 30, 2006, 2) May 31, 1999, to May 31, 2000, 3) Jan. 31, 1994, to Feb. 28, 1995, 4) Nov. 28, 1986, to Feb. 28, 1989, and 5) March 31, 1983, to Aug. 31, 1984. The starting date is the month-end date prior to first rate hike; the ending date is the month-end date of last cycle rate hike; current cycle end date is the latest month-end. Past performance is not a guarantee of future results.
Impact of repatriation
The newly signed Tax Cuts & Jobs Act of 2017 could result in modest increases in bank deposits and US money market fund balances as corporations are incentivized by lower tax rates to bring cash back onshore. While the amount and extent of repatriation remain to be seen, we believe these asset flows may be smaller than expected, and we anticipate limited impact on money market rates in the near term. We believe any increases in US money market fund balances due to repatriation are likely to be orderly and relatively short-lived, as corporations ultimately redeploy their cash to reduce debt, reward shareholders, increase capital expenditures, pursue mergers and acquisitions, and/or benefit employees. Regardless of the eventual use of cash, US money market funds and other cash equivalents should be an important parking spot for these balances.
Recent history has demonstrated the value of cash during a Fed tightening regime. We believe investors may wish to consider an active allocation to cash and conservative low duration strategies to capture these market dynamics that favor cash and potentially reduce interest rate risk.
- Investment Company Institute, as of Dec. 28, 2017
- Crane Data LLC, Crane Money Fund Average, as of Jan. 29, 2018
- US Federal Reserve, Dec. 16, 2015, to Jan. 31, 2018
- Bloomberg L.P., Nov. 30, 2015, to Jan. 31, 2018.
- US Federal Reserve, as of Dec. 13, 2017
- Invesco, Citi
Blog header image: carlo fornitano/Shutterstock.com
Past performance is not a guarantee of future results.
A basis point is one hundredth of a percentage point.
The Federal Funds rate is the rate at which banks lend balances to each other overnight.
Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.
Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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Will cash be king as the Fed hikes rates? by Invesco US