Author: Philippe Renaudin, Leiter of Money-Market-Teams, BNP Paribas Asset Management
At the beginning of March, investors appeared to be fully confident that the European Central Bank (ECB) would raise interest rates to 4% and the US Federal Reserve (Fed) to 6%, and that they would hold these levels for several quarters to stave off inflation to push back to the target value of 2%.
However, a financial crisis ensued when regulators shut down a US regional bank. This prompted markets to revise downwards the target level for policy rates expected for this cycle. As regional banks tightened their lending standards to small and mid-sized companies, and a credit crunch loomed, investors saw an increased risk of a recession in the US economy.
We remain convinced of the scenario of a moderate recession in the US and weak growth in the euro zone. The markets’ distrust does not abate, although the US authorities have taken swift measures to ensure market liquidity and financial stability.
The central banks immediately announced steps to stabilize the market regime. However, there is no sign that they will make concessions on their second mission: maintaining price stability.
We believe that persistently high core inflation, particularly in Europe, will require a restrictive monetary policy for some time to come. Therefore, we assume that official interest rates have not yet peaked.
Figure 1: Eurozone core inflation continues to rise
This is also suggested by recent central bank forecasts and comments, including their comments on the financial turmoil. The ECB announced that the recent tensions on the financial markets are an additional factor of uncertainty; however, it did not change its baseline scenario and hence monetary tightening stance.
The Fed indicated that “additional tightening of monetary policy may be warranted” to contain inflation. Some Fed officials reiterated intentions to raise interest rates above 5% (so expect some more rate hikes) and to keep real interest rates positive for some time to come.
Figure 2: Our baseline scenario for the US
What are the consequences for the money markets?
Over the past year, the Fed and ECB have made massive changes to monetary policy. The ECB raised its deposit rate by 350 basis points (bp): in summer 2022 it was still in negative territory at -0.5%, now it is +3%. Fed tightening was 475bps, leaving the fed funds rate in a 4.75% to 5% range.
After a long period of very low interest rates, money market funds are now attractive again. This is supported in particular by the extremely uncertain economic outlook and the prospects for risky investments against the background of slowing economic growth.
Figure 3: Our baseline scenario for the eurozone
Money markets: strong risk/reward profile
With money and equity markets currently offering high returns, which are fully priced in, money market investments represent a good alternative for those with a strong risk-reward profile. Money market funds, especially short-term ones, may be ideal for investors in volatile stocks or diversified products Solution.
The upside potential of equities, even assuming the optimistic soft-landing scenario, appears limited given current levels and unattractive when compared to cash or short-term fixed income returns. However, according to the Board of Directors’ forecasts in March, not even the Fed is counting on a soft landing anymore.
On the other hand, a mild recession could see stock markets revisit their previous lows and experience a significant downturn. Money markets and short-term fixed income securities not only offer ample downside protection, but also the opportunity to buy risky asset classes in the event of such a downturn.
Current Opportunities
Our approach to money market investing aims to accompany increases in policy rates by implementing floating rate strategies. This applies to strategies denominated in both US dollars and euros.
In the area of money market instruments, the forthcoming repayment of amounts borrowed from the ECB in recent years as part of targeted longer-term refinancing operations (TLTROs) is already leading to a significant increase in the outstanding amounts on the market for banks’ negotiable European commercial paper and similar financial issuers.
Bank issuers are interested in maturities of nine to twelve months. Non-financial issuers offer very short maturities (between one and four months). The latter represent a new diversification opportunity after being unavailable for a long time after March 2020 due to the switch to medium to long-term financing.
For money market funds, this is likely to mean more liquidity in relation to the maturities in which they are primarily active and potentially higher yields given the competition between issuers.
Compared to early 2022 levels, bank and corporate bond spreads have widened, adding another 25bps to money market fund performance. In our view, a continuation of this widening by a few more basis points is quite likely.
Given this large issuance and given Treasury bonds’ overvalued valuations, we do not believe it is appropriate to diversify our exposure to these issues at this time.
A revision of the European Money Market Funds Regulation (MMFR) is planned for 2024. Money market funds have easily survived the “stress test” of the pandemic. As the French Association for Asset Management (Association française de la gestion financière, AFG) recalled in response to the European Commission’s July 2022 consultation on money market funds: “No European money market fund has been suspended during the pandemic and every money market fund has announced the redemption of its Shares guaranteed.»
Conclusion
We believe that recent events at financial institutions have demonstrated the effectiveness of our proprietary credit analysis, which ranks issuers’ credit quality in accordance with the EU’s Credit Rating Agencies Regulation (CRA). According to the Rating Ordinance, asset management companies are obliged to assess credit risks internally and not solely to rely on ratings from rating agencies.
In our view, interest rate hikes and the normalization of other aspects of monetary policy from both the Fed and the ECB (such as the gradual reduction of their balance sheets) have made money market funds more attractive to investors. We will continue to actively manage our exposure while keeping an eye on opportunities in the market.