The money market fund rules change came and went (Rule 2a7 effective on October 14). We now have government funds yielding short-maturity T-bill rates and prime funds yielding more from their holdings of commercial paper and CDs. The government fund doesn’t break the buck. The prime fund may break the buck.
“You pays yer money and you takes yer choice” was the line used by the late William Safire in a famous NY Times column of 1988. He attributed the origin of the line to Mark Twain’s Huckleberry Finn. The modern version is something like “You get the yield you expect, aligned with the risk you take.”
Safire identifies the origin as “British, probably Cockney.” He explains that “The first time the saying saw print was in an 1846 Punch. A cartoon entitled ‘The Ministerial Crisis’ has a showman telling a customer, ‘Which ever you please, my little dear. You pays your money, and you takes your choice.’”
(William Safire, you are still sorely missed and will never be surpassed, in this writer’s opinion. We miss your words; your books still hold prominence in our library.)
But the characterization from Safire’s column doesn’t always apply. You may not have a choice if you are in a custody arrangement or brokerage firm system where the “govy” fund is preferred, since the prime fund has potential market price fluctuation. Over $1 trillion has shifted out of prime funds. Some went to govy funds; the rest went elsewhere. Prime fund balances still have a little under $400 billion and seem to be stabilizing.
So what happened to LIBOR after the rule change? Forecasters said it would decline. It didn’t and it won’t. Three-month LIBOR is about 90 basis points today. The correlation with 90-day Financial commercial paper has an R-squared of 0.95 (Source Citi).
Forward rates imply LIBOR will rise during the next year. One respected forecaster (Barclay’s Joe Abate) has 3-month LIBOR rising above 1% by yearend and heading for 2% by early 2018. That same forecast also has the Fed hiking once in December and three more times by early 2018. To sum it up, by spring 2018 that forecast is 1.9% for 3-month LIBOR, 1.5% for the Fed’s target policy rate (IOER), 1.5% on 3-month T-bills. To us, that forecast implies Govy funds about 1.35% and prime funds above 2%.
The Fed policy rate is set by the American central bank. The other US rates are market-based prices that are influenced by the Fed but contend with other forces, too. They demonstrate that the world is changing. This is not just about a money market rule change. This is about a reversal in the worldwide path of interest rates.
We believe the 35-year low in rates occurred in the two weeks following the Brexit vote. July marked a strategic low level in sovereign debt yields. In July, 10-year US Treasury yields flirted with 1.3%. That yield is heading above 1.85% today.
In the rest of the world, about $13 trillion of sovereign debt traded at a negative rate in July. That is out of a total of about $45 trillion. Since that extreme, the negative rate cohort seems to have peaked and may be declining. I’ve seen one estimate at $11 trillion.
With thanks to central banks like the ECB, weaker sovereign bond credits like Italy are scrambling to finance themselves with 50-year bonds even as they face serious political structural change. Italy’s vote is in December. The 5 billion euro issue yielded 2.85 %.)
Meanwhile, yield chasing global buyers are supporting those long duration bond issues with a relative yield comparison. Japan’s central bank is presently committed to a zero interest rate policy on its 10-year note. In the last year, Japanese inventors switched bond strategy from a cumulative net inflow of 5 trillion yen to a cumulative new outflow of 15 trillion yen (Source: Japan Insider). Remember Japan is the world’s third largest economy and second largest national capital market. The eurozone total is larger but it represents 19 countries.
The takeaway from all this has two elements. The first is credit. Get paid. And if credit risk rises in its usual nuanced way, get out and preserve your capital. Bonds and credit need to be surveilled and managed. With the wind no longer at the back of the bondholder, a passive buy-and-hold-until-maturity approach faces rising risk.
The second requirement is to manage duration risk. That is important. Duration is a complex calculation and is used daily by money management professionals. It needs to be respected by every investor.
At Cumberland, we are serious about credit. And we are very, very serious about our durations. They continue to shorten, and defense is our strategy on the bond market playing field.
Think of it this way. The 10-year US Treasury note hit 1.35% in early July and is now yielding 1.85%. If, in early 2018, the 3-month T-bill yield is 1.5%, the 1-year T-bill yields 1.75%, and 3-month LIBOR is about 2%, what do you expect the 10-year Treasury note to yield? Forward rate calculations suggest 10 year yields will be well above 2%. The reason to manage duration risk is obvious.
James Sweeney of Credit Suisse listed the “Fixed Income Anomalies: current policy rates – historically low; expected future policy rates – historically low; expected policy rate volatility – very low; term premium – lowest ever; credit spreads – normal; inflation expectations – low; nominal GDP growth – low; nominal GDP growth minus interest rates – very high!”
Thank you to James Sweeney. We agree. History shows it is the “real rates” that ultimately count.
Interest Rates and William Safire
David R Kotok, Chairman and Chief Investment Officer
Cumberland, November 1, 2016