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Balancing money markets
It’s been a challenging 12 months for central banks globally since Northern Trust Asset Management announced in October 2022 that veteran Federal Reserve advisor Antulio Bomfim had been hired as head of Global Macro, a newly created position within its global fixed income group. A year on, inflation remains well above the respective targets of central banks in the US, the UK and Europe, and Bomfim notes a concerted effort to tighten the stance of monetary policy in the face of “a surprisingly resilient economy and stubborn inflation.”
According to Bomfim, from the perspective of the money markets, the past year has been a period of having to think carefully about extending maturities, given expectations that major central banks may not be done with rising rates. In the US, he adds, debt ceiling negotiations in Washington DC did little to curb excitement in the money market space, particularly those focused on the dollar or government securities.
“We’re now getting to a point where here in the US, and also in the Euro area and the UK, we see central banks as being at or very close to the peak of their respective policy rates. One of the effects of this is that investors in the money markets are becoming more comfortable extending the weighted average maturity of their holdings, where we are seeing weighted averages drifting higher,” he explains.
The question now is, other than yield, what should investors be bearing in mind when choosing a money market fund?
“Higher yields are there to compensate investors for higher risk. Investors need to understand the risks embedded in a security or portfolio and assess whether they are being properly compensated for their risk, whether that be liquidity risk or credit risk involved in strategies that go beyond investing in the safety of government securities,” notes Bomfim.
“Having a research-based and well-established investment process by a money manager who will do the necessary due diligence on your behalf is fundamental,” he adds.
Using credit risk as an example, he points to certain issues relating to the banking sector that occurred over the last 12 months in the US which also had repercussions for the European and UK markets. “Investors need to be careful not to end up with the wrong credit exposure. Higher yields come in different shapes and forms, and we need to ensure that we are getting the right yields in line with the right risk.”
And while Bomfim does not expect the US interest rates to rise much further, concerns relating to the strength of the US dollar are often on the minds of Asian clients. However, one of the characteristics of the last 12 months or so is just how surprisingly resilient the US economy has been in the face of very aggressive rate hikes, not just by the Fed but also the ECB, the BoE and other major central banks. The relative strength of the US economy, he says, bodes well for the strength of the US dollar, which has become an even more important factor recently given rising political tensions in the Middle East, on top of the war in Ukraine.
“When global investors, whether in Asia, in Europe, or even the US, get stressed or sense a heightened concern or potential for market turmoil or geopolitical risk, they tend to flock to the safety and security of dollar denominated assets, particularly US Treasuries. If you're looking for that type of safe investment, you need to buy dollars first. These two forces bode well for the continued strength of the dollar,” he explains.
Higher yield environment
So does Bomfim see the prospect of a higher yielding environment as the new normal, or can we expect yields to return to those of pre-Covid times?
“In my view, especially in the money market space, we are at or close to peak levels of yield both here in the US and in Europe, given just how far central banks have gone in terms of raising their respective policy rates. We’re also starting to see some signs of inflation moderating and this has implications for where we go from here,” he explains.
“We are likely to stay at significantly higher yields than we were before the pandemic for some time, and while inflation is moderating, it is still too high relative to central banks’ targets. I don’t see central banks being in a hurry to be cutting rates any time soon.”
He also points to what he sees as the central banks’ greatest fear, that current high levels of inflation become persistent and where investors, business leaders and consumers in general allow such levels to become in entrenched in their psychology to the point where central banks start to lose credibility in terms of their inflation targets.
“This is a key reason why, in the money market space at least, yields are unlikely to return to pre-Covid levels any time soon. Interest rates and policy rates rose fast and are likely to stay at a higher plateau for a while. Once rate cutting starts, central banks will be closely monitoring to ensure that we are on a firmly established downward trend on inflation, relative to their targets,” he adds.
Longer duration positions
With weighted average maturities longer than they were a year ago and even six months ago, Bomfim sees money market investors becoming more comfortable extending duration. The issue, however, is not simply a result of their respective central banks reaching the peak or rate hikes, nor indeed the resolution of issues relating to debt ceiling negotiations in the US.
“We are seeing attractive market opportunities outside the global money market to the yield curve as a whole up to ten years and beyond, where we are seeing value in extending durations in our portfolios in terms of what we have seen in recent weeks in the market run up at the longer end of the US Treasury curve. That process has already started, and I think this will likely pick up pace as we seek to add clarity on whether we are at the peak or not.”
One trend Bomfim expects to continue in the money markets is investors taking greater comfort in extending durations. And as we move forward and begin to see confirmation that we are indeed seeing inflation trends becoming even more favourable, he believes that this will only add to the appetite for longer duration within the money markets.
But what other factors make cash investment or money market funds such a viable proposition in these uncertain times?
“Even in normal times it’s always prudent to have some part of your portfolio allocated to these highly liquid and safe assets. Today, there is still a lot of uncertainty around central banks and whether the effects of their past actions have already been felt through the economy or whether there is still more to come. The question of how long this resilience will last is a very natural one, and if you look at the situation through the eyes of an economist, you have to look at the inflection points in the economy.”
However, he warns that these points are hard to navigate or forecast and are fraught with risk. Macro uncertainty is just one argument for having an allocation to cash type investments, he says, and the argument is only stronger now given that we have heightened global macro uncertainty and geopolitical risk right now.
“We pride ourselves on an investment process that is research driven and risk aware and this has served us well. The proof is in the pudding, and we are seeing our clients vote with their feet in terms of either increasing their allocations to us or in terms of welcoming new clients. We’ve seen healthy positive inflows year to date and have delivered competitive yields without having to take outside risks,” he asserts.
“We’re in a very unique cycle and we’re not yet out of that cycle. Recession risks have diminished but they are still there. And in the same way that the Fed Chair likes to say that they are proceeding carefully on the monetary policy front at this stage, we are carefully scouring the macro data in the US and globally, looking for opportunities and assessing risks to make sure that when we do deliver yield that we feel we are being properly compensated for the risks that are inherently behind those higher yields,” he adds.
To conclude, Bomfim sees Asian investors playing a big role in the US Treasury market given the region’s economic linkages with the US and the role of US Treasuries as an investment vehicle of choice.
“It’s a mutually beneficial arrangement for the US Treasury and Asian investors seeking safe and liquid assets. I think US Treasuries will continue to play a key role in Asian investors’ portfolios, and that role might become even more important now, especially given the global tensions we’re experiencing.”
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