Liquidity management in a rate-cutting environment

It’s been 20 years since rates were cut in response to falling inflation and slowing growth. Rather than the policy easing stance during other times of crisis, news reports continue to tell us that markets expect a certain percentage in rate cuts from various central banks.

However, it is crucial to understand the implications of such action on liquidity and portfolio management, especially with money market funds in mind.

Look at market pricing, for example, which is an average of participants’ expectations. Imagine there are just two market participants, where one expects no change in rates at the next meeting, while the other forecasts a cut of 0.50%. Paradoxically, the market implied pricing – an average of 0.25% cut – represents the view of neither participant.

This needs to be considered from a portfolio perspective, too. Portfolios are positioned based on our views in comparison with those of the market. We won’t extend weighted average maturity (WAM) just because we are expecting rate cuts. Instead, we will extend WAM if we believe the market is under-pricing rate cuts. In any event, liquidity provision is the core objective, with a focus on client concentrations and seasonal flows.

At the same time, portfolio construction encompasses a wide range of risk management techniques with credit, liquidity and duration positioning at the fore. Primary measures to describe duration and credit exposure are WAM and weighted-average life (WAL), which measure the average portfolio sensitivity to rates and credit exposure. Again, we find these average measures useful but not the whole picture.

More specifically, portfolio managers are bound by WAM and WAL constraints but when analysing and constructing portfolios, we concentrate on maturity buckets and relative pricing – for example, the one- to three-month part of the curve versus six to 12 months. We may judge that one bucket is fairly priced, while the other is too cheap or expensive. We will then allocate accordingly to the more attractive bucket. The distinction between fixed and floating rate securities is equally important.

With these and other factors influencing liquidity and portfolio management, it is important amid today’s macro backdrop to consider how 2024 might develop, and how key trends can impact money market funds – a valuable resource for investors throughout economic cycles and rates environments in ensuring preservation of capital, daily liquidity, diversification and risk management.

So, with this in mind, we spoke with John Chiodi, chief investment officer, liquidity Americas. He has been managing money market funds since the early 2000s, and has more than 30 years of money market experience overall.

What are your expectations for the economy, inflation, and central bank rates?

John Chiodi (JC): The US economy continues to chug along. Strong GDP prints were posted during 3Q23/4Q23, the labour market remains resilient and inflation has been heading in the right direction. That said, markets are still divided on when the US Federal Reserve (Fed) will first cut and how much cumulative easing will be realised during 2024. Recent jobs and inflation data has convinced some market participants that the Fed has more latitude to keep rates higher for longer. Indeed, at the beginning of the year, Fed Funds futures implied 150 basis points (bp) of cumulative easing, whereas today this figure stands closer to 80bp. We are inclined to lean towards more cuts than what’s currently being priced in. However, it’s important to note that expectations for the Fed’s path forward have been very volatile as of late and data dependant.

How do you position your portfolios given your views?

JC: Given the uncertainty surrounding the timing and scale of Fed cuts, we are confident about one thing: rates will most likely fall this year. To position for this, we’ve been biased towards maintaining longer WAM across our US dollar (USD) money funds. On the other hand, to protect against a “higher for longer” scenario, we’ve also been layering in floating rate investments at attractive spreads which would benefit should the Fed become more hawkish. Right now, it’s a balancing act of lengthening WAM and WAL.

What does this mean in terms of portfolio construction?

JC: As a priority, portfolio positioning needs to ensure provision of liquidity to our shareholders, a critical input to which is shareholder liability profiles, which support liquidity ladder optimisation to achieve natural maturities to deliver on expectations of flows and seasonality. We will always try to look for relative value at different parts of the curve and on a security-by-security basis. From a portfolio construction standpoint, our current investment views call for running a longer portfolio WAM and WAL. In other words, extend maturities on fixed-rate instruments and buy longer-dated floaters.

What are the risks to your views?

JC: The most obvious risk to our core view is stubborn inflation. To date, inflation has responded very well to Fed tightening, cooperating for the last several months and drifting downwards, closer to the Fed’s 2% target. Should this story change and inflation stall its descent and/or heat up, the Fed may find itself needing to hold/cut less. This would also beget the possibility of a potential hike, though we judge this very unlikely. In any case, we believe that we’ve constructed the portfolio to perform well in a falling rates regime but have also hedged against the chance of higher inflation via floating rate notes.

How do you think money market funds will respond to today’s environment?

JC: A lot of people in the industry have been focused on what US money fund flows will look like this year. Recall that money fund assets have enjoyed strong growth over the last few years and currently comprise about US$6 trillion in assets under management (AUM) in the US onshore market alone. Fund flows, regardless of whether they are inflows or outflows, can cause passive changes to portfolio liquidity and maturity profiles, and as a result, influence the decision making of portfolio managers. Historically, money fund assets have increased during the early innings of Fed cutting. Additionally, decisions from the Fed on how to proceed with quantitative tightening may influence the level of reserves in the system and hence aggregate money fund AUM. We’ll be paying close attention to flow volatility this year and invest accordingly.
 

For more information, please visit https://www.assetmanagement.hsbc.com.hk/en/institutional-investor/investment-expertise/liquidity

_{Source: HSBC Asset Management, 31 December 2023}

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