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The state of money market yields following Fed action

Wells Fargo Investment Institute - July 26, 2021

Key takeaways

  • The Federal Reserve’s (Fed’s) actions taken in June 2021 served toslightly increase the yield of certain securities held in money marketfunds. Money market fund yields remain positive, and the slight increase in yield has been supportive of fund net asset values, whichhave generally remained slightly above $1.
  • Money market yields have declined notably since the Fed reduced thefederal funds rate in early 2020. Current expectations are that the Fedwill keep rates at low levels with the first rate hike coming in early 2023.

What it may mean for investors

  • We believe that the economy appears solid, and that this is not the end of the cycle or the bull market. We believe that long-term investors should focus on implementing their investment plans, which should include asset allocation, diversification, and rebalancing.
  • With the Fed’s zero interest rate policy still in place, fund yields are verylow and we expect them to stay relatively low over the next few years.For investors looking to invest new assets in the money market space,we favor Treasury and government money funds.

In early 2020, the “flight to quality” during the onset of the coronavirus pandemic had investors keenly focused on liquidity and potential risks in money market funds. The Fed’s actions taken during that turbulent time in the markets served to enhance liquidity in the broader markets and in money markets more specifically.

Since the onset of the pandemic, the foremost development for money market investors has been the downward trend in yields. With the Fed instituting a zero interest rate policy early in 2020, money market fund yields trended consistently lower over the course of last year and into this year. This has led some investors to wonder about the possibility of fund yields turning negative or money funds closing.

The Fed provided some relief from these concerns in June 2021 when it made upward adjustments to the interest on excess reserves and the reverse repurchase agreement (RRP). So far, these adjustments have been effective in pulling rates above the zero lower bound and in setting a floor on money market rates.

Factors affecting ultra-short-term markets

Loose financial conditions over the past year have increased liquidity, and although this has been a positive for economic growth, it has created pressures in the short-end of the curve as there has been too much cash chasing few short-term investments. At the same time, the Fed continues to create $120 billion in reserves each month due to quantitative easing, and this also has had an effect as it reduces overall available supply.

Additionally, the Treasury’s General Account (TGA) balance remains elevated, and the expectation is for the balance to come down ahead of the debt ceiling suspension expiration at the end of July. A decrease in net Treasury bill (T-bill) issuance could most likely exacerbate the supply and demand imbalance in money markets. If this persists, we expect RRP facility usage and the number of counterparties accessing the facility to continue to climb.

In our opinion, once the issue of the debt ceiling limit is resolved, the Treasury most likely will increase issuance of T-bills and short-dated securities in the fourth quarter of 2021. The Fed, on the other hand, will most likely be preparing for tapering by that time. We believe the combination of these events should provide some additional relief to the funding pressures currently experienced.

RRP facility usage increases as the TGA balance declines

RRP facility usage increases as the TGA balance declines

Sources: Wells Fargo Investment Institute and Bloomberg as of July 20, 2021. Left panel chart: daily data from July 1, 2019 to July 20, 2021. Right panel chart: weekly data from July 3, 2019 to July 14, 2021. RRP = reverse repurchase (repo) agreement. TGP = Treasury’s General Account.

What it may mean for investors

The Fed’s increase in its RRP interest from 0 basis points to 5 basis points (100 basis points is equal to 1 percent) effectively increased the yields of money market securities such as U.S. Treasury and U.S. agency securities. In addition, since the latest Fed action alleviated the near-term pressure for managers to maintain a positive yield, we would also expect a lessening in the perceived need for money fund providers to close funds.

While these positive developments have certainly been welcomed by money market fund managers, we believe fund yields experienced by investors will likely remain very low for some time. We have generally observed slight increases in gross fund yields (yields before fees) for many funds, while net fund yields (yields after fees) have remained essentially unchanged at very low levels. This is primarily due to managers using the incremental yield to reduce the amount of fees they are currently waiving for investors.

Another key dynamic currently in place among money funds is the historically low incremental yield advantage that can be gained by investors moving from a Treasury or government money market fund to a prime money market fund. Given the very small yield differential and the incrementally higher level of risk associated with prime funds, we favor Treasury and government money market funds over prime money market funds for investors looking to invest new money in the money market space.

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