For many investors, cash-equivalent strategies remain an important source of liquidity and relative stability – even in the low yield climate we’ve seen in recent years. Yet it’s an arena where the dynamics are changing. Important shifts in the economic and regulatory landscape are likely to impact short-term markets in the days ahead. Here, we offer five key events to watch for and the implications we think investors should anticipate.

Fed Rate Hikes – As Soon As This Summer
The Federal Reserve hasn’t raised interest rates in nearly a decade, but a stronger jobs market and recovering U.S. economy mean the central bank could begin tightening policy in the second half of 2015. We expect the pace of rate increases, however, will be moderate.

  • Impact on short-term markets: In previous rate cycles, higher interest rates have been good for savers using bank deposits or money market funds. We believe this time will be different. Banks, which are bearing higher costs post- Dodd Frank regulations, have few incentives to pay more on deposits, and in some cases are turning them away. And high demand for short-term government securities and the scarcity of them should make it difficult for money market funds to generate higher returns.

  • Bottom Line: It could take a 75-100 basis point rise in the Federal Reserve’s target rate before anything meaningful is passed on to users of deposits or money market funds. Positioning around the pace of tightening could benefit actively managed strategies.

The Fed’s Use of New Monetary Policy Tools When It Seeks To Raise Rates
The Federal Reserve has several tools outside of the Fed Funds Rate that it will likely use to help remove the unprecedented amount of monetary stimulus in the financial system and raise rates smoothly. 1/ Interest On Excess Reserves, or IOER, is the interest rate – currently 25 basis points – the Fed pays banks to hold their excess reserves at the Fed; and 2/ Federal Reserve Reverse Repo Program, which was set up in January 2014. Both rates theoretically should give the central bank more precise control on short-term rates when it begins to tighten policy.

  • Impact on short-term markets: Unknown, which is why investors will want to see how the usage and level of rates of these various programs responds to Fed rate hikes.

  • Bottom Line: The Fed’s tightening policy could look much different this time and make for more volatile short-term markets as it uses a number of tools to get its tighter policy just right.

Inflation Expectations
Eventually, a recovering economy will likely cause consumer prices to rise and, more importantly, influence investors and consumers to expect higher inflation in the future.

  • Impact on short-term markets: Such a recalibration of expectations means money funds and other short-term investments will need to generate higher nominal returns in an attempt to provide real returns, i.e., ones that surpass inflation.

  • Bottom Line: Higher inflation could make it more difficult for cash-equivalent strategies to break even in what is expected to be a continuing low interest rate environment.

Money Market Reform Concludes In 2016
Under new Securities and Exchange Commission regulations, institutional prime (credit) money market funds will transition from a fixed net asset value (NAV) of $1 per share to a floating NAV and have potential fees and gates on withdrawals. Government-only money market funds will retain a $1 NAV and are unlikely to have fees and gates.

  • Impact on short-term markets: Already, several large money market fund managers have announced shifts to their fund lineups, including converting some prime funds to government-only funds. We expect a significant increase in demand for government-only money market funds.

  • Bottom Line: Institutional investors specifically will need to consider the risk of investing in prime money market funds where their principal is no longer pegged to a $1 fixed NAV. If they opt to go into a government fund, they must consider that a) yields are likely to remain near-zero and b) some of these funds may close to new investors due to the scarcity of short-term government paper.

Quantitative Easing Outside of the U.S.
The European Central Bank has recently joined other central banks such as the Bank of Japan in an aggressive bond buying program that could add over a trillion dollars to its balance sheet. Its quantitative easing program isn’t due to end until the third quarter of 2016 and could potentially be extended.

  • Impact on short-term markets: Bond yields on some sovereign European bonds have turned negative, making it undesirable to hold cash. However, there are opportunities for investors who can take advantage of the divergence between the U.S. and the rest of the developed world, such as identifying countries where yields have the potential to come down further.

  • Bottom Line: In efforts to generate attractive yields, cash investors must be flexible and look globally for opportunities.
The Author

Jerome M. Schneider

Head of Short-Term Portfolio Management

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Disclosures

Jerome Schneider is head of the short-term and funding desk at PIMCO.

Money market funds may only invest in certain high quality short term investments issued by the U.S. government, U.S. corporations, and state and local governments that are subject to strict diversification and maturity standards and ultra-short bond funds are not subject to these requirements. Further, money market funds seek to maintain a stable NAV of $1.00 per share. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. PIMCO provides services only to qualified institutions and investors.

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