A Tipping Point for Public Cash Managers

Money market interest rates have held quite steady this year while the stock market, long-term bonds and financial futures have bobbed and weaved in response to turbulent tariff news and shifting views of recession risks. Public treasurers and cash managers have lost nothing so far by staying ultra-short in their portfolio maturities, but external, outsourced managers running public money against popular indexes in the one- to three-year range have outperformed most others. That’s because notes maturing in 2026 and 2027 have produced capital gains on top of coupon income, resulting in total returns this past year of 6 percent versus 4-ish percent for those who stayed short.

But that’s now just history. The challenge for public cash managers is what to do next.

Normally, interest rates on bonds and money market instruments give investors a higher yield for longer maturities to reflect liquidity preference, market segmentation and market risk on longer-term paper. The current yield curve for U.S. treasuries is showing a relatively rare configuration: a “swayback” formation in which yields for investments maturing between four and 30 months are successively lower but thereafter increase as maturities lengthen, as would normally be expected. Therein lies the challenge for today’s governmental money managers.

This chart illustrates the recent swayback formation (the hump at four months reflects recent market jitters about debt-ceiling default risks):
This is a reflection of market expectations that the Federal Reserve will cut its overnight interest rate, the Fed Funds rate, later this year and into 2026. That’s because the general presumption is that the economy is starting to weaken and that presidential tariff turmoil will settle into something more predictable with a tariff of 10 to 15 percent on most countries’ imports. That would imply a bump in the CPI inflation rate into the high 3 percent range but not much more. Whether that jolt then feeds into future labor costs and services prices is yet unknown. But if the economy starts to soften and joblessness increases, then the Fed can rationally shift from its current stance of moderately tight monetary policy to a neutral position.

If that’s the case, then the Fed Funds rate could reasonably drift down by about a half-percentage point by year-end without re-stoking inflation — or so the thinking goes. The aforementioned Treasury yield curve would then look pretty flat in the range of one month to one year, while retaining its normal upward slope for longer maturities. So those who lock in today’s rates on one-year paper would likely come out ahead, but they will have to keep explaining to overseers and stakeholders the mathematical logic of that strategy in the face of today’s higher returns on shorter-term investments.

Most futures market traders keep thinking that overnight rates will go even lower in 2026, with the Fed Funds rate settling in around 3.5 percent in a year or so. The result is a slight technical discrepancy between the cash market’s Treasury yield curve and the futures market curve, which favors cash managers who can lock up their 2026 rates despite the “inverted” swayback in the cash market yield curve. But it’s important to keep in mind that neither of these markets are explicitly reflecting the upside-or-downside possibilities of worse economic outcomes resulting from the financial shock of tariffs. Right now, those hedges are offsetting each other in the markets’ pricing structures.

The Short and the Long of It

For those who think tariffs will cause more inflation than the White House asserts and markets are now internalizing, the optimal strategy would be to stay relatively short, investing no longer than four months, while waiting for inflation to prove so stubborn that the Fed needs to keep overnight rates unchanged or even higher. They could then re-invest their maturing paper at better rates.

Those on the other side of that bet would anticipate a Trump Slump as consumers put away their wallets and tariffs cut into their consumption rates, with businesses facing lower sales and profit margins forced to trim payrolls. Or some may simply believe that lower gas and egg prices will offset most tariff impacts. Even if inflation remains above the central bank’s long-term target of 2 percent, rising unemployment would force it to cut the overnight rate to something closer to 3 percent or possibly even less. Longer maturities purchased today, even at somewhat lower rates, would then look brilliant.

One interesting wrinkle in this outlook is how local governments react in coming months to the potential disparity in yields on various local government investment pools (LGIPs). The LGIPs that operate like money market mutual funds, with very short-term maturities, would be expected to see their yields hold up around 4 percent until the Fed starts reducing its overnight interest rate — assuming it does. But those like the California Local Agency Investment Fund, which typically invest in maturities averaging longer than 200 days, will continue to live off their unrealized capital gains because they do not mark to market, valuing their assets and liabilities based on current market conditions. If the Fed does cut rates, don’t be surprised if eligible local agencies dive into those pools this fall to capitalize on the higher yields from older portfolio holdings.

Larger Fiscal Issues

For most state and local government officials, the outcome of all this strategizing will be secondary to other economic consequences of the tariff wave heading our way once the presidential pauses expire. What seems pretty certain is that most state and local governments’ interest income on operating cash will be lower in the coming fiscal year, no matter what.

And other revenue categories will likely dwarf the budgetary impact of forthcoming money market fluctuations: Losses of income and sales tax receipts will probably overshadow the decline in interest income, and tariff-induced price inflation could easily translate into higher employee compensation rates. Cuts in multiple federal aid programs and cost-shifting from the federal to state governments will dwarf variations in operating-portfolio interest income. That focuses attention elsewhere and away from cash managers.

From that perspective, the nuances of cash management at this point will seem like inside baseball. For treasurers who manage the public’s cash themselves, there is always the strategy of simply “laddering” their investment maturities to match the cashflow forecasts from the budget office and splitting the rest between equal maturities of 4 and 12 months as a hedge against extreme outcomes either way.

For external money managers of governmental operating funds, who are evaluated on their performance against benchmark indexes, the next six months will test their mettle and their portfolio skill. Those who simply mirror their index will fail to earn their management fee but will probably at least keep their jobs because “who knew?” is always a safe excuse. This would be an appropriate year for low and flat management-fee structures.

Longer term — which in cash management is more than 12 months — it’s highly likely that next May the president will appoint an “easy money” Federal Reserve chairman, which suggests a bias toward lower overnight interest rates thereafter. Part of the swayback yield curve is probably anticipating that move. But that kind of politics will likely come at a cost of higher long-term yields as the bond vigilantes sniff out monetization of the swelling federal deficits.

The bottom line is that even though there is considerable uncertainty about the future rate of inflation and thus the direction and timing of Federal Reserve monetary policy and short-term interest rates, the markets have discounted most of that already. As a result, the average cash manager is unlikely to find very many low-risk opportunities to outshine others until the likely inflation impact of tariffs is more obvious, presumably around Labor Day. Until then, staff time is likely spent better on other priorities, like finding ways to trim organization-wide fiscal 2026 expense budgets to match other revenue shortfalls thrust upon them by cost-shifting Washington politicians.

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Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment advice.