Liquidity Management in a Falling Rate Environment

Start with the Eurozone, the economy has already stalled and inflation is falling. This is not quite recession but there is stagnation. We think that could deteriorate further and, yes, rate cuts will be the result. We do look for a heavy and sharp cutting cycle with a low of perhaps 2 per cent and initial cuts of maybe 50bp in size. Our view has differed from how the market has been pricing cuts; we see this happening a little later than currently priced due to continued elevated services inflation and a central bank that will want to err on the side of caution. But, once started, rates will come down as quickly as they went up.

In the UK, growth prospects are a little rosier and inflation measures, including wages, remain stubbornly high. Here, we feel the market is more appropriately priced with two to three rate cuts for GBP this year.

Unlike the Eurozone, the US economy continues to chug along. Strong GDP figures were posted during 3Q ’23/4Q ‘23, the labour market remains resilient, and inflation has been heading in the right direction. That said, markets are still divided on when the Fed will first cut and how much cumulative easing will be realised during 2024. Recent jobs and inflation data has convinced some market participants that the Fed has more latitude to keep rates higher for longer. Indeed, at the beginning of the year, Fed Funds futures implied 150bp of cumulative easing, whereas today this figure stands closer to 80bp. We are inclined to lean towards more cuts than what’s currently being priced in. However, it’s important to note that expectations for the Fed’s path forward have been very volatile as of late and data dependant.

The Australian economy is expected to slow as rate hikes, inflation, and higher rents impact real incomes with additional headwinds from slowing global growth, uncertainty around the Chinese economy and the impact of geopolitical events. Inflation has peaked and, from a high level, is on a disinflationary trend. Markets are pricing 40bp of rate cuts by December 24. The timing of rate cuts feels too early to us given the level of inflation, the RBA’s inflation target, labour market tightness and tax cuts. Unlike the Fed, BoE and ECB, the RBA has hiked a lot less and the need for earlier easing is commensurately reduced. We expect the RBA to be on hold for most of 2024 with the possibility of rate cuts only in 4Q ’24.

Policy easing has already started in China, and we expect 2024 to be a better year than 2023 in terms of economic growth. China’s initiatives to deleverage the economy since 2017 has caused widespread pain. While we expect efforts to reduce debt will continue in the long term, we believe top-down policies in 2024 will put more emphasis on economic growth. In terms of inflation, we expect it to return in 2024 but remain low. Given the outlook of stable growth and modest price pressures, we expect more monetary easing to support growth. Policy easing will remain moderate and incremental as authorities try to manage competing policy objectives, such as currency stabilisation and net interest margin stabilisation for the banks.

In the Eurozone, we view the market to be too aggressive in pricing rate cuts and so our WAM is relatively short. In the UK, we believe that markets are more fairly priced and so WAM is a little longer. For both currencies, we continue to make use of floating rate investments that offer attractive credit spreads for longer maturities. Such investments offer attractive current yields as well as good carry in the event of postponed or less aggressive rate cuts from the central banks.

Given the uncertainty surrounding the timing and scale of Fed cuts, we are confident about one thing – rates will most likely fall this year. To position for this, we’ve been biased towards maintaining longer WAM across our USD money funds. On the other hand, to protect against a ‘higher for longer’ scenario, we’ve also been layering in floating rate investments at attractive spreads that would benefit should the Fed become more hawkish. Right now, it’s a balancing act of lengthening WAM and Weighted Average Life (WAL).

We expect the RBA to hold for most of the year, but we also expect a pronounced narrowing in credit spreads once the central bank signals an easing bias. Therefore, we adopt a somewhat barbell approach to positioning, locking in spreads in longer maturities balanced by shorter investment maturities around key RBA meetings like May (post 1Q ’24 CPI data) as well as have natural maturities for possible quarter end outflows. We would look to extend further selectively if paid appropriately.

The RMB is composed of onshore and offshore markets with important structural differences between the two. These two markets react to different extents to changes in onshore monetary policy. The onshore market is more directly impacted by monetary policy and liquidity conditions in China, while the offshore market is also sensitive to specific factors such as external RMB demand, as well as monetary policies in other parts of the world. For instance, after the policy easing in January, offshore rates increased rather than decreased. We believe this is because the PBoC has a strong desire to maintain FX stability and as such, liquidity in the offshore market tightened. Before the US embarks on an easing interest rate path, we expect this unique feature of the offshore market to continue, leading to more favourable rates in the offshore versus the onshore market. Our strategy is therefore to maintain a high level of liquidity in the absolute short end to take advantage of the volatility in this part of the curve. Meanwhile, as always, we will maintain a diversified liquidity ladder and selectively extend into three to four months if we are paid appropriately.

It is important to understand that WAM is an average. As portfolio managers, we are bound by WAM and WAL constraints but when analysing and constructing portfolios we concentrate on maturity buckets and relative pricing for, say, the one to three-month part of the curve versus six to 12 months. We may judge that one bucket is fairly priced while the other is too cheap or expensive. We will then allocate according to the more attractive bucket. The distinction between fixed and floating rate securities is equally important.

This point is perfectly illustrated by the relative positioning in six to 12-month investments in euro and sterling portfolios. As already mentioned, we believe that the UK market is priced closer to our own expectations and we further note that the combination of interest rate and credit pricing in sterling produces longer-term investment opportunities that are close to, but above, the current overnight yield. We are therefore more comfortable to allocate to fixed rate investments in the six to 12-month month portion of the sterling curve than in euros where we prefer floating rate securities that benefit the portfolio in the event that interest rate cuts occur later than the market expects.

Similar to the euro and sterling, for US money funds we always try to look for relative value at different parts of the curve and on a security-by-security basis. From a portfolio construction standpoint, our current investment views call for running a longer portfolio WAM and WAL. In other words – extend maturities on fixed-rate instruments and buy longer-dated floaters.

It’s important to remember that all positioning is subject to the need to provide liquidity to our shareholders. As well as WAM and WAL, positioning portfolio construction is also informed by shareholder liability profiles to ensure we optimise our liquidity ladder and have natural maturities to deliver to what we expect in terms of flows and seasonality. From a credit risk standpoint, as we look to extend tenor in fixed rates, we target higher quality names.

When it comes to portfolio construction to implement our view, we look for the best relative value opportunities among different instruments. We typically use deposits at the absolute short end while buying CDs/ CPs/residual maturity bonds for longer trades as these instruments tend to offer a premium over deposits. We also look at relative valuations between the onshore and offshore markets and allocate to these markets accordingly.

We consider portfolio positioning by balancing our core view with the primary risks of this view. In sterling, we judge the main risk to our view to be a sharper deterioration in the UK economy than expected. In such a scenario, we would expect some widening in credit spreads but price improvement on the duration dimension. Our longer dated trades are only with issuers of the highest credit quality in line with our primary objectives of principal preservation.

In euros, earlier rate cuts are not our primary risk view. In fact, we look for later cuts than the market, hence our allocation to floating rate product at attractive spreads. Should the market move towards our view then we would implement a lengthening in WAM by increasing allocation to the six to 12-month fixed rate maturity bucket.

The most obvious risk to our core view is stubborn inflation. To date, inflation has responded very well to Fed tightening, cooperating for the last several months and drifting downwards closer to the Fed’s 2 per cent target. Should this story change and inflation stall its descent and/or heat up, the Fed may find itself needing to hold/cut less. This would also bring about the possibility of a potential hike, though we judge this very unlikely. In any case, we believe that we’ve constructed the portfolio to perform well in a falling rates regime but have also hedged against the chance of higher inflation via floating rate notes.

The primary risk to our view is the possibility that the RBA puts one more rate hike through if it feels inflation is starting to stagnate and not keep to its expected trajectory. The floating rate investments held in the fund mitigate this risk to a certain degree. We hold a significant proportion of the portfolio in the zero to one-month bucket, which could quickly be deployed at higher yields should the risk scenario materialise.

The key risk to our view is slower-than-expected growth recovery in China resulting in authorities’ greater tolerance for RMB depreciation and structurally lower interest rates in the offshore market. In such a scenario, we would look to extend maturity in fixed rates by utilising our current shorter dated positioning to lock in rates in the three to six-month space. Geopolitical tensions between China and the US may also add extra uncertainties in our outlook for the economy and the currency.

Yes, very much so. Two interesting examples spring to mind. First, in the Eurozone perhaps more than other markets, the reduction of system liquidity via so called quantitative tightening (QT). On face value, the continued process of reduced system liquidity should benefit money funds as bank issuers show increased appetite for short-dated issuance. Indeed, that would be a good thing, however, we must factor this aspect into pricing (market and our own). The other is perennial but worth mentioning as we move towards rate cuts. As liquidity fund managers, we need to ensure that portfolios are positioned with sufficient liquidity to meet investor needs, always. Even in a perfect hypothetical scenario where markets price rate hikes and we have 100 per cent conviction of cuts, portfolio construction must be mindful of sufficient liquidity provision.

A lot of people in the industry have been focused on what US money fund flows will look like this year. Recall that money fund assets have enjoyed strong growth over the last few years and currently comprise about $6tn in assets under management (AuM) in the US onshore market alone. Fund flows, regardless of whether they are inflows or outflows, can cause passive changes to portfolio liquidity and maturity profiles and as a result influence decision-making by portfolio managers. Historically, money fund assets have increased during the early innings of Fed cutting. Additionally, decisions from the Fed on how to proceed with quantitative tightening may influence the level of reserves in the system and hence aggregate money fund AuM. We’ll be paying close attention to flow volatility this year and invest accordingly.

In common with other markets, emergency liquidity provision is being reduced in the AUD market. Around AUD 100bn of Term Funding Facility rolls off bank balance sheets in the coming months. This could result in some liquidity tightening and potentially lead to higher bank bill rates via widening spreads as the supply of liquidity reduces but demand remains the same.

As noted earlier, the RMB money markets are highly technical in nature, requiring the closest of attention to systemic liquidity supply/demand, policy intervention, the interaction between on and offshore markets and the external macroeconomic environment. We will be closely tracking developments in these areas, with a focus on interest rate differentials between the RMB and other major currencies. While markets broadly expect the US Fed to cut rates this year, markets still lack consensus on the timing of the first cut and the depth of this cutting cycle. We will continue to monitor the change in fundamentals between China and other major markets to reassess our position.