Portfolio Manager Commentary

Overview, strategy, and outlook: As of March 31, 2014

Federal Open Market Committee recap

Federal Reserve (Fed) Board Chair Janet Yellen made a big splash at her initial press conference following the FOMC’s March 19 meeting, and by big splash, we mean the “OMG” kind, not the “Oooo-ahhhh” kind. The statement released after the meeting and the forecasts by Federal Open Market Committee (FOMC) members that accompanied it seemed to take a decidedly more hawkish tone. The removal of the explicit 6.5% unemployment rate as a benchmark for beginning the tightening phase was not a surprise. After all, we are on the edge of 6.5% now and no one really thinks the Fed is ready to tighten monetary policy yet, especially considering it’s still in the process of easing through the quantitative easing asset-purchase program, albeit at a slower pace. But the shift of the FOMC members’ federal funds rate forecasts from a median rate of 1.75% at the end of 2016 to 2.25% and from 0.75% to 1.00% at the end of 2015 seemed to signal a move toward a more aggressive rate posture.

So, if the markets were thrown off balance when Yellen started the press conference by saying, “…this change in our guidance does not indicate any change in the committee’s policy intentions…” then we were knocked over when, in response to a question, she clarified that the term “a considerable period”—a linchpin in the FOMC’s strategy of forward guidance—meant six months! Surely no one expected her to put a number on it, let alone one so small, and bond and stock prices immediately fell. That precise definition immediately shaved a half point off the 3-year Treasury note (T-note) and a quarter point off the 2-year T-note. While the stock and long bond markets rebounded fairly quickly, short and intermediate bond yields remain elevated.

Money market yields, however, experienced little impact; indeed, one could make the case that a more bearish view by short-term bond investors might actually put downward pressure on the yields of money market securities due to sellers parking the proceeds of their sales in a market that has a relatively static supply.

We would expect that the Fed’s shift to a policy of optimal control will entail rates staying low for longer than economic conditions might indicate on the surface; that’s what the Fed is trying to tell us in their statement when they say, “…it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset-purchase program ends…” At its current pace, the Fed’s asset purchases will end sometime in the fourth quarter of 2014, and if “considerable time” really means six months, as we have been told, then we are looking at our first rate hike in the April–June 2015 time frame. So, how does that square with the committee’s forecast for a 1% federal funds rate at the end of 2015? In the past, others have noted a disconnect between the FOMC’s economic and federal funds forecasts, so this could just be a similar situation. Alternatively, it could also mean that since the policy of optimal control not only calls for rates to be lower for a longer period of time than other models might call for, there could also be a more rapid rise in rates once policy shifts.

Market participants who are expecting a gradual tightening on the order of 25 basis points (bps; 100 bps equals 1.00%) every other meeting or so may be surprised at the magnitude of rate hikes when they do occur, and portfolios positioned for a gradual increase may find themselves terribly out of sync with market conditions. But who can really blame them? For a group that has promoted transparency in an effort to provide clearer forward guidance for investors about its monetary policy, the Fed left the waters very muddied after this meeting.

Is there a surprise rate spike in store?

While interest-rate movements are not solely dependent on central bank intentions—at least not yet—and market forces still determine the path of interest rates, those forces are not exclusively influenced by the invisible hand. Regulatory activities can create incentives that alter the behavior of market participants and affect activity and pricing, sometimes wildly. One market that is ripe for such a disruption is the federal funds market.

The federal funds market traditionally provided a means for banks to lend and borrow1 excess reserves held at the Fed. If excess reserves are plentiful, there are more sellers (lenders) and the rate falls. If excess reserves are in short supply, there are more buyers (borrowers) and the rate rises. Since the total amount of reserves in the system is always determined by the Fed, the federal funds rate can be increased or decreased by removing or adding excess reserves from the system. This is how monetary policy worked prior to the onset of the financial crisis in 2007 when total reserves were around $6 billion.

1. In the parlance of the federal funds market, lenders of excess reserves sell and borrowers of excess reserves buy. 

But in an age when total reserves are now $2.7 trillion and are moving higher due to the Fed’s asset-purchase program, adding or subtracting a relatively small amount of reserves doesn’t change the fact that the system is awash in excess liquidity. Further, most banks no longer need to purchase excess reserves because almost everyone has far more than they need or want. Moreover, since the Fed now pays banks interest on their excess reserves (IOER), there is no need for banks to find a way to earn interest on them, so most banks are no longer sellers of reserves, either. Yet, the federal funds market continues to trade, albeit at significantly lower volumes and with markedly fewer participants. Who are these participants and why are they still trading federal funds despite IOER?

The daily effective federal funds rate is the dollar-weighted average of all trades reported in the federal funds market. As shown in the chart, although the Fed’s target for the federal funds rate has been at 25 bps for what now seems like forever, the effective federal funds rate has been as high as 22 bps and as low as 4 bps since the start of 2010. The low end of the trading band has ranged from 0 bps to 15 bps, while the high end has ranged from 31 bps to 65 bps.

The federal funds market

Chart: The federal funds market

Source: Bloomberg L.P.
Past performance is no guarantee of future results.

On the high end of the range are a few presumably distressed banks that have to pay above-market rates in order to meet the Fed’s reserve requirements. Most of the volume in this market is at the low end of the trading range as some federal agencies, which are large depositors at the Fed but are not legally entitled to IOER, are selling to the U.S. branches of foreign banks, which are able to buy from these agencies at less than 10 bps and collect 25 bps of IOER from the Fed. This is a more advantageous arbitrage for the foreign banks because, unlike their U.S. counterparts, they do not offer insured deposits and thus are not liable for FDIC assessments on their excess reserve balances. This goes a long way toward explaining why the foreign banks hold $1.4 trillion of the total $2.6 trillion that’s in the system. More recently, it seems that Fannie Mae and Freddie Mac have shifted their activity from the federal funds market to repurchase agreements (repos), leaving the Federal Home Loan Banks responsible for a large majority of the selling.

It is widely expected that U.S. regulators will exempt reserves from the Basel III supplementary leverage ratio calculations that we discussed in some detail in our August 31, 2013, commentary, but the big question for the federal funds market is whether the Fed’s counterparts in other countries will provide the same exemption. Remember that, unlike
risk-weighted capital ratios, the supplementary ratio applies to a wider range of on- and off-balance-sheet assets and without regard to their relative riskiness.

Foreign bank regulators may not feel that they owe the Fed any favors, especially after the Fed ruled that U.S. branches of foreign banks needed to be separately capitalized through an intermediate holding company—a move that was seen in some circles as an expression by the Fed of a lack of confidence in the ability of their fellow regulators to adequately supervise the capital structure of their banks’ U.S. operations. While there is a phase-in period for Basel III, reporting begins in 2015 and banks will want to be in compliance with the Basel standards well in advance of the reporting date.

If foreign banks are required to pledge capital against their reserves, it would make the arbitrage trade between federal funds and IOER unprofitable. The foreign banks might also step away from other low-risk funding markets, such as those for time deposits and repos, causing rates in those markets to fall. On the other hand, less involvement in the federal funds market would have the opposite effect. If their creditworthy counterparties step away, the FHLBs could reasonably be expected to follow Fannie Mae and Freddie Mac into the repo market. Because the effective federal funds rate is a weighted average, the absence of these low-rate trades would lead to a significant uptick in the effective rate, causing it to consistently trade above the Fed’s target rate rather than below it. At the same time, a shift of activity away from the federal funds market to repos could lead to lower rates on that front.

Rates for sample investment instruments
Current month-end % (March 2014)

Sector

1 day

1 week

1 month

2 month

3 month

6 month

12 month

U.S. Treasury repurchase agreements (repos)

0.05

0.05

0.04

0.06

U.S. Treasury bills

0.03

0.03

0.05

0.12

Agency discount notes

0.01

0.02

0.03

0.05

0.06

0.07

0.13

LIBOR

0.09

0.12

0.15

0.19

0.23

0.33

0.56

Asset-backed commercial paper—First Tier

0.13

0.13

0.15

0.18

0.21

Dealer commercial paper—First Tier

0.11

0.11

0.10

0.12

0.13

0.15

Municipals—First Tier

0.06

0.06

0.07

0.08

0.10

0.11

0.15

Sources: Bloomberg L.P. and Wells Capital Management
Past performance is no guarantee of future results.

 

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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 3-31-14 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.

Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For a current prospectus and, if available, a summary prospectus, containing this and other information, visit wellsfargoadvantagefunds.com.