Public Cash Managers, Prepare for Interest Rate Liftoff

The stock and bond markets are all atwitter about “the taper”: expectations that over the next year or so the Federal Reserve will cut back on the massive bond purchases it’s been making throughout the pandemic. More and more pros are expecting higher bond yields, which often deflate the market value of other financial assets. But that’s only half of what 2022 holds in store. Once the Fed’s “quantitative easing” throttles back, it’s only a matter of time before it will have to start jacking up short-term interest rates.

Those prospects present a range of implications for public-sector cash managers. Those are the folks focused primarily on short-term rates in the money market, which include Treasury bills, high-grade corporate commercial paper, federal agency and bank notes, money market mutual funds, and repurchase agreements (the latter with banks and bond dealers).

Their operating budgets’ cash reserves cannot be risked in the price swings of long-term bonds. Unlike the 1970s and 1980s, when inflation and Fed policy pushed short rates to high single digits and even into double digits, and cash management was producing a big sliver of state and local government operating budgets, the near-zero interest rates of recent years have shrunk the budgets of treasury departments because there isn’t enough return on invested cash to warrant staff expenses. As a result, many municipalities have outsourced their short-term investments to state treasurers’ low-fee investment pools, money market mutual funds and commercial money managers, where economies of scale suppress administrative and professional costs.

Meanwhile, American public cash managers can't really look abroad for guidance on how to navigate this changing landscape. Unlike other G-7 central banks that pushed their overnight interest rates down to zero or lower, the U.S. Fed has kept its overnight rate at 25 basis points (1/4 of one percent). In part, this policy was designed to preserve the money market mutual fund and external cash management industries by allowing overnight interest rates for consumers to remain positive after fees. For money market mutual funds, consumers typically get paid one basis point (0.01 percent) on their cash, with the rest consumed by fees, but it’s not a negative number as is often the case in Europe, where savers actually must pay a fee to store their money. Domestic public cash managers who invest in short-term paper directly can still eke out a small but positive interest rate on their liquid assets.

Duration Risk and Opportunity Costs

In a money market like today’s, the interest rate on investments is modestly higher on paper that matures further out in the future, like a year or two. It’s not much, but for some investors it’s better than nothing, and when interest rates are descending, aggressive cash managers have been winners by locking up those higher rates on longer maturities. But when inflation and interest rates subsequently increase, the reverse will be true: The longer-maturity investments may fail to compensate for the rising rates, and may even lose principal value if sold in the open market to pay bills. The longer the maturity, the more market prices will decline. That’s called “duration risk” — the threat of principal losses when market rates increase. And even if the investments are held to maturity, they suffer opportunity costs: the loss of the chance to reinvest for a shorter term at higher rates. Both outcomes are suboptimal from the perspective of public-sector budgets.

That’s where tapering comes in. Financial market traders are now obsessed with the timing of the Fed’s anticipated curtailment of its persistent long-bond purchases, as that will send a signal that long-term interest rates are heading higher and that the central bank no longer feels compelled to provide accommodative monetary stimulus to the economy. What nobody in the media is watching these days is the short end of the market. It’s almost taken as a given that short-term rates will remain pegged near zero for many months to come, long after bond yields begin to drift upward. Even the sophisticated financial futures market anticipates only minuscule changes in the short-term Fed funds rate for at least a year.

Nevertheless, public cash managers would be wise to prepare for the possibility of at least a single step upward in the overnight interest rate by early 2022, as the Fed begins to tighten its monetary policy. A tiny step of 1/4 percent would not crash the stock market, but it would sober up some of the excess enthusiasm and appetites for risk, and it would signal to savers that they don’t need to gamble with their money in order to earn at least a pittance on their capital. A small uptick would also send a powerful message to the foreign exchange markets, thus bolstering the dollar, which helps tamp down commodity inflation.

Threading the Monetary Stimulus Needle

Historically, going back to the last century, it’s been more typical that short-term interest rates would be closer to the inflation rate than to zero. Otherwise, savers are smarter to spend now before prices increase further, and such behavior stokes inflation. In 2022, it’s now conceivable that the Fed will slowly but systematically begin jacking up the short-term overnight money rates. If inflation is still running above 2 percent next year and short-term rates lag below the rate of inflation, as many expect (even including many Fed officials), savers and short-term investors will continue to lose purchasing power. So the Fed will need to thread the needle by softly removing its monetary stimulus without spooking the bond and mortgage markets with abrupt rate increases that will snuff out the nascent economic recovery. The Fed’s governors prefer to operate like an aircraft carrier, not a ping-pong ball.

That’s a reasonable baseline scenario. But if consumer price inflation and salary increases persistently exceed 3 percent by mid-2022, especially in light of rapidly rising rents and house prices, money market and especially 1- to 5-year bond rates will simply have no place to go but up, lest the bond vigilantes begin to fear that the Fed has lost control. One way to think about this is that money market interest rates cannot indefinitely remain below the pace of salary increases paid to municipal workers, which reflect “core” inflation. If government salaries start escalating by 3 percent annually in 2022, which I suspect they will, then money market rates below 1 percent could stoke inflation fears. That is a scenario for which prudent public cash managers and treasurers should be prepared, and which oversight officials must discuss with them.

My outlook represents a cautionary contrarian view that is still early, but I suspect it will be borne out in next year’s capital markets. I’ve seen and forecast this rodeo back in earlier decades. It’s the kind of mid-cycle rate upswing that caused the most infamous investment losses in municipal history.

It’s too soon to start building short-term investment income increases into state and local budgets, but by next spring that is probably a safe expectation. In the meantime, public cash managers and those who oversee them should take a closer look at their portfolio structures and strategies to make sure that they don’t sucker themselves into overextending their maturity ladders. Don’t expect the sky to fall in the money markets before next year, but keep some powder dry going into the new year, when zero may no longer be the baseline.

And think twice about holding bond maturities that extend longer than 2022 for operating funds and cash reserves. Nobody wants to repeat the notorious local government investment losses of 1984 and 1994, when cyclical interest rate spikes blew up two treasurers’ risky portfolios as America’s economy shifted into higher gear. As traders say, it’s foolhardy to pick up pennies ahead of a steamroller by reaching into riskier longer maturities to scrounge for a minuscule yield advantage today.

---

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 to buy, sell or hold a specific security. Public investors should confer with their advisers and oversight officials regarding prudent strategies.