Portfolio Manager Commentary
Overview, strategy, and outlook: As of December 31, 2013
When we go over the past years' commentaries, we are always amazed at the range of topics that merited some mention, and this year was no exception.
After coming off the excitement of the fiscal cliff that was supposed to accompany the budget sequester in 2012, January was comparatively quiet. Interestingly, we noted that "in mid-January, investors began to flee from Treasury bills (T-bills) with maturities around the end of February, which, at the time, was widely expected to be the time frame the U.S. would reach the limit." In our February commentary, we discussed another event that the market feared but turned out to be a big nothing: the removal of the unlimited FDIC insurance on non-interest-bearing transaction accounts (NIBTA). Widely expected to significantly decline, NIBTA balances actually increased in the fourth quarter of 2012, as did balances in institutional money market funds. We also examined the relationship between the amount of repurchase agreement (repo) collateral in the market and repo rates, developing a rule of thumb that repo rates were adjusting by one basis point (bp; 100 bps equals 1.00%) for every $10 billion change in available collateral.
In March, we revisited the European bailout mechanisms developed by the European Central Bank (ECB), the European Union (EU), and the International Monetary Fund (IMF) as they were tested by the near-failure of the banks in Cyprus. The Cypriot financial system was among the most highly levered and, at seven times the size of the economy, dwarfed the resources of Cyprus. Still, the system had escaped close scrutiny due to its relatively small size in relation to the rest of the EU's banks, a fact that ended up being its saving grace.
We discussed the EU's proposed financial transaction tax (FTT) in April, an ill-conceived idea that would have derailed the money markets in Europe, along with negatively affecting other financial markets. While the EU's version hasn't gained additional traction, the FTT appeals to spendthrift politicians desperately seeking new sources of revenue. We also talked about how market participants were flattening the yield curve by extending maturities to add incremental yield.
Our May commentary reported the changes to the London Interbank Offered Rate (LIBOR) that came from the recommendations of the Wheatley Commission. After May 31, the British Bankers' Association (BBA) ceased publication of "tenors for which there is insufficient trade data," and dropped postings for 2 weeks, 4 months, 5 months, 7 months, 8 months, 10 months, and 11 months. Seven months later, we can't say they've been missed. May was also the first month in which we commented on the possibility of the Federal Reserve (Fed) tapering its quantitative easing (QE) program, a topic of which we quickly grew weary in the ensuing months.
In June, we also reported that the BBA ceased publication of the submissions of individual LIBOR panelists. We noted that while "regulators are almost uniformly calling for more frequent and detailed disclosure in all areas of the financial markets, the problems with LIBOR stemmed from the disclosure of too much information too quickly." We also discussed the potential effects that a change in Fed activity might have on money market rates and the supply of eligible investments.
After taking a month off, our August commentary dealt with new bank capital ratios and the unfavorable effect they were having on the repo markets, at least from our vantage point. We also mentioned a new tool in the Fed's monetary policy toolbox, a reverse repo (RRP) fixed-rate full allotment facility. After a fairly brief mention in the minutes of the Federal Open Market Committee's July 30–31 meeting, our September commentary reviewed the early result of the tests of this new facility and its success in relieving supply shortages over the September 30 quarter-end.
The September commentary discussed another looming conflict over the U.S. debt ceiling and why we felt this was more about show than substance. In October, we reviewed the events around the debt ceiling fight and why a U.S. default was never a danger, at least from a purely financial standpoint. We hate to miss a month discussing new regulation, and there never seems to be a shortage of conversation material these days, so we also discussed the Fed's proposal for the implementation of the Basel III-compliant liquidity coverage ratio in the U.S.
And finally, November's commentary discussed the rollout of a major new product in the money markets slated for January: U.S. Treasury floating-rate notes (FRNs). Met with some excitement from certain quarters, they generate less enthusiasm from us. As we noted, they do not provide new supply but are largely replacing T-bills. While the FRNs are expected to offer a spread to T-bills, they also require the investor to take more duration risk, and it may be difficult to gauge whether or not they represent good value over their entire two-year life. With the first auctions on tap for January, you'll hear more about them soon.
Rates for sample investment instruments
Current month-end % (December 2013)
|Sector||1 day||1 week||1 month||2 month||3 month||6 month||12 month|
|U.S. Treasury repurchase agreements (repos)||0.01||0.01||0.04||–||0.07||–||–|
|U.S. Treasury bills||–||–||0.01||–||0.05||0.06||0.12|
|Agency discount notes||0.03||0.01||0.04||0.06||0.09||0.12||0.16|
|Asset-backed commercial paper—First Tier||0.11||0.12||0.17||0.20||0.23||–||–|
|Dealer commercial paper—First Tier||0.13||0.14||0.16||0.18||0.20||0.28||–|
Sources: Bloomberg L.P., Wells Capital Management
Past performance is no guarantee of future results.
On the horizon
As we prepare to close the books on 2013, we look forward to 2014 and the challenges that await us. New types of instruments, a shift in Fed policy away from asset purchases in favor of strengthened forward guidance, new regulations, and continuing developments on the credit front will all present their unique challenges.
What seems unlikely to change is one of the foremost challenges facing money market investors—extraordinarily low interest rates. We see a number of factors that could affect money market yields over the next year. On balance, they tend to suggest even lower rates to begin the year, with rates perhaps rising gradually by the end of the year but all within the near-zero rate range that has wearied investors for the past five years. That's right—it's been five years since the Fed lowered its target rate to a range of 0 bps to 25 bps, on December 16, 2008. Even as the economy shows signs of life, money market investors are halfway to their own lost decade.
Looking to the demand side, government securities will continue to be sought to collateralize over-the-counter derivative transactions, while the Basel III liquidity coverage ratio and other similar regulatory requirements will drive banks to hold more liquid securities, including government debt. Banks currently meet much of their liquid securities requirements with reserves held at the Fed, but as the Fed balance sheet potentially tops out later this year with the end of its asset purchases, the banks' needs for government securities should grow.
On the supply side, 2014 will start with a reduction in T-bills outstanding, as the Treasury will issue fewer T-bills to make room for its new floating-rate notes, due to debut at the end of January. This net T-bill pay-down should squeeze rates early, as the timing will coincide with the debt ceiling reset in early February, but it should be relatively short-lived, persisting only until the debt ceiling is once again lifted.
A more pervasive weight on rates will be the ongoing drain of repo collateral by the Fed as it continues buying securities via its QE program, potentially through most of 2014. Even though it has begun to taper its purchases, if the Fed reduces them gradually throughout the year, it will still stand to buy between another $400 billion and $500 billion in 2014. When (if?) QE finally winds down, repo rates could rebound a few basis points as the market attempts to find a new equilibrium.
The financial crisis, gone but not forgotten, will continue to be felt in the form of increased regulation on a number of fronts, with various impacts on rates. Banks have been and will be pressured to continually reduce their reliance on wholesale funding and increase the term of their liabilities, leaving them with a reduced need to finance their balance sheets in the repo market. The supplementary leverage ratio looks to be one of the primary levers to that end, as it would encourage banks to shrink their assets and liabilities, a task most easily accomplished by cutting their repo books. This has already taken place to varying degrees, and it's hard to see the process abating. Whether regulatory authorities have correctly diagnosed the problem, much less prescribed the right medicine, remains to be seen and will no doubt provide ample material for countless future Ph.D. candidates.
Regulatory and accounting changes are also expected to continue to compress the supply in the asset-backed commercial paper market, with supply of municipal variable-rate demand notes and tender option bonds also being eroded. Reduced supply leaves investors with fewer options, weighing on rates.
The two wild cards in the short end are both held by the Fed. They're potentially related, and either could significantly change the functioning of the money markets. First, the Fed could lower the interest rate it pays on excess reserves (IOER) from its current level of 25 bps. Depending on the degree of the change, such a move could materially change the willingness of banks to borrow through the repo and time deposit markets and park the proceeds at the Fed, a practice that currently drives a significant portion of money market activity. Such a move would obviously push rates lower, perhaps even below zero. The second big unknown is whether and how the Fed will use its fledgling RRP facility. Currently in a test phase through January, declaring the facility as permanent and full allotment could effectively establish a floor on rates, perhaps offsetting the effect of a cut in IOER. On the other hand, the Fed could just as easily declare the test a success and shutter the program until it's needed to control rates more closely during a tightening cycle.
Overall, a Fed that is very committed to being very easy for a very long time, combined with regulations tending to increase demand and reduce supply, point to another year of low money market rates. Only a percolating economy and resulting nervous bond market wary of inflation seem to be risks to this view, but even then the Fed seems sufficiently steadfast that 2014 would be too early for it to move in nearly any circumstance.
Our aim is to continue to assess the possibilities and developments in the markets, and their risks and rewards, and construct money market fund portfolios that will be resilient in the face of these challenges.
A portion of the Municipal Money Market Fund's income may be subject to federal, state, and/or local income taxes or the alternative minimum tax (AMT). Any capital gains distributions may be taxable. For the government money market funds, the U.S. government guarantee applies to certain underlying securities and not to shares of the fund.
The views expressed and any forward-looking statements are as of 12-31-13 and are those of the fund managers and the Money Market team at Wells Capital Management, subadvisor to the Wells Fargo Advantage Money Market Funds, and Wells Fargo Funds Management, LLC. Discussions of individual securities, or the markets generally, or any Wells Fargo Advantage Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.