Manager, US Dollar Fund
Manager, Euro and Sterling Funds
Cash Market Prospects in 2018 - Q&A with SSGA Cash Portfolio Managers
As 2018 gets under way, we took the opportunity to quiz two of SSGA’s prime fund portfolio managers about the year ahead.
Sean, what are you focusing on as 2018 begins?
“The Federal Reserve’s path of administered rates is definitely a primary focus. Decent economic growth, strong asset appreciation, steady employment gains, and increasing confidence – both consumers and businesses – has allowed the bank’s Federal Open Market Committee (FOMC) to remove some of the extraordinary accommodation of recent years; it raised interest rates three times in 2017. Positive economic growth data has also allowed the FOMC to view lower core inflation as transitory while still anticipating it will reach their 2% target.”
So what action will the Fed take in 2018?
“The FOMC’s summary of economic projections indicates continuing rate normalization, with three more hikes in 2018 – which matches the forecast of our in-house economists. But history cautions that ‘events’ and data can derail plans, and the FOMC stresses it is not on a predetermined path. Indeed, not all futures markets are pricing in three hikes; market makers seem hesitant to fully price them in with core inflation still around 1.5%.
The Fed governors recognize that core inflation needs to be higher, which is challenging given the already-low unemployment level, and economic data trends will remain key to rate action. In our US dollar funds, we continue to focus on liquidity and duration management against this evolving rate backdrop.”
What are your credit concerns?
“We are focused on bank regulatory changes, US yield curve flattening and geopolitical risks. Increased bank regulation, in terms of higher retained capital levels and liquidity ratios, has bolstered bank balance sheets and improved credit-worthiness. However, some rules restrict banks’ capacity to lend and drive economic growth, and elections have brought pledges to loosen regulations. If this is done prudently, and banks retain adequate capital buffers, then credit should remain strong. But we will watch for material changes to credit-worthiness.
Amid increased short-term funding costs, resultant yield curve flattening means a lower spread or net interest margin for long-term investors. With US short-term rates to rise further, profits and economic growth may be pressured, impacting spreads and economic fundamentals.
Geopolitical risks lie with ongoing Brexit negotiations, while pockets of populist sentiment in the EU persist despite election disappointment in 2017. China’s territorial claims and sanctions against North Korea are risk factors, with the potential to affect credit flows throughout the Asia-Pacific region. Asia-Pacific banks have a large presence in the US and are significant borrowers of US dollars.
Generally, our conservative credit approach has avoided headline risk and is focused on the most well-capitalized and highly-liquid institutions within specific regions.”
How has liquidity been?
“Liquidity has been good. In the first half of 2017, credit spreads tightened – recovering nicely from spread-widening triggered by US money market reform in late 2016. Dealers have continued to inventory paper at reasonable bid-ask spreads, but the depth of the balance sheet is below that prior to increased regulation. We anticipate a healthy supply of treasury bills in Q1 and hopefully through 2018. This benefits cash investors as it should push security yields higher relative to Libor and the Federal Funds rate, as well as increase the amount of repurchase agreement collateral within the system.”
Mihaly, what does 2018 hold for Europe?
“A key narrative is the ECB’s scaling back of its asset purchase program from €60bn to €30bn per month until September. This was well-telegraphed and we don’t anticipate any near-term impact on cash markets. However, we remain cautious about sovereign rates and the risk of a ‘taper tantrum’ in the latter half of 2018. Back when the Fed began tapering its asset purchases, that was also well publicized but there was still a significant back-up in yields.
Markets expect the ECB will announce – in May or June – either the elimination of its program or another reduction in purchases. We will be focused on the ECB’s language given the potential for volatility.
And how do you see euro and sterling markets in 2018?
“The cash market in Europe should be similar to 2017. The deposit rate is -0.40%; repo rates tend to trade below that and the term yield curve is still flat. While the curve has steepened of late, with longer forward rates moving higher, we don’t see rate hikes on the horizon. Banks continue to be well funded and significant excess liquidity remains in the system. There is over €1.8 trillion of excess deposits at the ECB and this has grown alongside the bank’s portfolio of purchased assets. Credit spreads are at historically tight levels and demand for newly-issued debt has been robust.
Clearly, the UK situation is different. The Bank of England raised rates in November and the forward curve has priced in additional hikes. However, I suspect the market will tread carefully. There is much at stake with Brexit negotiations and many outcomes are possible. We continue to manage the sterling fund cautiously; supply has been ok, so investing the UK portfolio has not proven overly-challenging.”
Supply is something we hear a lot about.
“The supply of short-term debt has shrunk considerably amid reduced risk appetite or opportunity cost and regulatory reform. Regulators made the system safer, but safety comes at a price. So while banks have better funding, and risk assets have been greatly reduced, the cost of high-quality liquid assets is high.
The spread between prime and government money market funds is 20-30 basis points, in both Europe and the US. Prior to 2008, this spread dipped below 10 basis points. The investments are available but yields are now lower, and sometimes significantly negative.
Lastly, many dealers stop issuing debt around quarter-end to reduce the overall size of their balance sheet for accounting purposes, often causing yields to drop below their intra-quarter ranges. The Fed resolved some of these market dislocations with their Reverse Repurchase Program, whereby the Fed borrows money from investors in return for treasury collateral. The ECB has considered this and alternative programs to alleviate such challenges, but nothing thus far has been implemented.
The opinions are those of the author and are subject to change based on market and other conditions. The information should not be construed or relied upon as investment advice. You should consult your financial advisor. Investing involves risk including the risk of loss of principal.