With central banks raising interest rates at the fastest pace in recent history, money market funds have gained in popularity for investors seeking attractive risk-adjusted returns. But what happens now that the interest rate hiking cycle is expected to pause or reverse course?
Against an uncertain monetary policy backdrop, we discuss why high-quality cash remains attractive, offering downside protection as well as higher yields, for cautious income seekers.
Against a backdrop of rapid rate rises, money market funds (MMFs) are typically able to increase their yields at a faster pace compared with bank deposits, for example. When bond yields reach their peak - as we think they are close to doing - extending the term of the paper in MMFs takes advantage of the higher yields on offer. Below, we examine the outlook for interest rates, how it may impact money market strategies, and what investors can do to optimise their allocation.
To hike or not to hike
The market consensus is that the central banks will need to cut interest rates as soon as later this year (see chart). Yet inflation also remains decidedly stubborn. Despite some signs of softening, inflation still exceeds key central bank targets. In the UK, wage growth, energy costs and ongoing supply chain challenges have contributed to persistent inflationary pressures.
And given recent upside data surprises, the Bank of England may be further from the interest rate peak than expected.
Interest rate hiking cycles, bank of England vs. the Fed
Earlier this month, US Federal Reserve Chairman Jerome Powell said he does not expect inflation to decline quickly, signalling resistance against the market consensus. We believe it would have to be a severe economic recession for the Fed to begin cutting interest rates before the end of the year, as is currently priced in by the forward markets. Therefore, we believe, interest rates will remain ‘higher for longer'. This is inherently positive for MMFs, where yields and total returns are driven for the most part by central bank rates. A higher-for-longer interest rate trajectory could potentially yield 4.5% to 5% for MMFs in US-dollar terms in the next three, six and 12 months.
In this elevated interest rate environment, MMFs will likely remain attractive from a risk-adjusted return perspective relative to other asset classes, including equities. Take the spread between the three-month US dollar London Inter-Bank Offered Rate (Libor) and the S&P 500 equity dividend yield, which is the largest since the 2007-2008 global financial crisis (GFC). From this perspective, investors might receive a higher income stream from US-dollar MMFs than owning US equities while taking a fraction of the risk (see chart).
While we do not believe interest rate trends will reverse anytime soon, even if they eventually fall, MMFs have some key advantages. Relative to bank deposit rates, yields in MMFs may stay elevated for longer as central banks cut rates. This is because money market strategies can extend the maturity of the instruments held in the portfolio to increase the term premium.
Money market yield minus equity dividend yield, USD
Risk controls
No matter which direction interest rates are heading, however, there are active decisions investors can take to manage downside risk more effectively. Money markets traditionally have very little exposure to interest rate or credit risk. However, a robust, disciplined, and independent credit research process is a critical foundation for building a money market strategy. For example, our proprietary research covers more than 900 issuers based on a combination of quantitative and qualitative assessments alongside market factors to build an approved issuer list with a minimum rating of A and A2 by S&P and Moody's, respectively.
Sustainably liquid
Increasingly, an important consideration when assessing money market strategies is how environmental, social and governance (ESG) characteristics influence outcomes. Although the securities within a money market strategy tend to be short term in nature, long-term sustainability improvements are material because the same issuers often refinance or issue a series of short-term debts.
To assess ESG risk more granularly, an effective ESG engagement strategy that encompasses analysts across asset classes and regions is needed. In 2022, for example, Fidelity International conducted 1,464 engagements with more than 1,100 issuers, focusing on measurable improvements, both directly and in collaboration with other stakeholders. These engagement activities help inform investment decisions.
A safer harbour
Recent central bank action has propelled MMFs to the top of the list for many investors seeking attractive risk-adjusted returns with relatively low volatility, low interest-rate sensitivity, and capital preservation potential. Just as MMFs provided investors with a way to quickly benefit from rising interest rates, they may also help protect yield as policymakers slow or reverse course. In our view, money market strategies remain a safer harbour amid higher market uncertainty, particularly over the direction of central bank policies.
This post is funded by Fidelity International
Important information
This information is for investment professionals only and should not be relied upon by private investors. The value of investments (and the income from them) can go down as well as up and you may not get back the amount invested. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Fidelity's fixed income range of funds can use financial derivative instruments for investment purposes, which may expose them to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The value of shares may be adversely affected by insolvency or other financial difficulties affecting any institution in which the funds' cash has been deposited. A Money Market Fund (MMF) is not a guaranteed investment. Investment in an MMF is different from an investment in deposits. The principal invested may fluctuate, and the risk of loss of the principal is to be borne by the investor. The MMF does not rely on external support for guaranteeing the liquidity of the MMF or stabilising the NAV per share. Issued by Financial Administration Services Limited and FIL Pensions Management, authorised and regulated by the Financial Conduct Authority. Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. UKM0623/381792/SSO/NA
