The Fed Stays On Its Fairly Hawkish Path

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1 LEADERSHIP SERIES OCTOBER 2017 Money Markets The Fed Stays On Its Fairly Hawkish Path Michael Morin, CFA l Director of Institutional Portfolio Management Kerry Pope, CFA l Institutional Portfolio Manager Key Takeaways Stable economic growth appears to support the U.S. Federal Reserve s plan to raise rates in December. The Fed expects to begin tapering its balance sheet in October, possibly benefiting short-term yields. A debt-ceiling impasse has been temporarily avoided, potentially improving supply-demand technicals in the near term. We believe Fidelity s money market mutual funds are well-positioned for a December rate hike. We are closely watching the Trump administration s proposal to overhaul the U.S. tax code. Supply-demand dynamics in the repurchase market are improving. Economic strength underlies plans for gradual tightening We believe the Federal Reserve (Fed) remains on track to raise target interest rates by a quarter-point in December, based on the strength of the U.S. and global economies. A December hike would mark the Fed s third such rate increase in The U.S. economy expanded at an annual rate of 3.1% in the second quarter, revised upward from a previous reading of 3.0%, according to the U.S. Department of Commerce s final figures, released in September. Consumers, who account for more than two-thirds of economic demand in the U.S., increased their spending by 3.3% in Q2. Meanwhile, businesses continued to expand rapidly. Nonresidential fixed investment, a measure of business spending that includes equipment, software, and commercial space, rose 6.7%. Outside the U.S, the world s largest economies grew steadily and largely in unison. Global exports rose 3.5%, reflecting continued improvement in global demand for goods and services.

2 The eurozone, while not as far along in the economic cycle as the U.S., continued to benefit from improving credit conditions and overall market sentiment. European Central Bank (ECB) President Mario Draghi remained upbeat, saying in June that the region s economic recovery has both broadened and accelerated. He added, however, that the ECB must remain patient, and that the recovery must result in stronger inflation before monetary accommodation can be meaningfully reduced. In Draghi s view, downside risks are largely geopolitical, as he believes the region s economy is now strong enough to withstand a mild slowdown in China, where industrial activity and the housing markets recently have stalled. Most economists now believe the U.S. economy can expand anywhere from 2% to 2.5% in the third quarter, continuing to remove slack from the system and supporting further rate hikes. Many economists slightly lowered their forecasts in September, however, due to an active hurricane season in which hurricanes Irma and Harvey caused billions of dollars of damage in Texas, Florida, and parts of Louisiana. Federal Open Market Committee (FOMC) members, at their most recent meeting in September, seemed to downplay the potential economic impact of the hurricanes. Of note, the Fed s median guidance for policy rates remains higher than that of market expectations, based on Fed funds futures (Exhibit 1). Balance-sheet tapering is scheduled to begin in October The FOMC also confirmed plans to begin the gradual process of paring back the $4.5 trillion worth of Treasury bonds and mortgage-backed securities on the Fed s balance sheet, beginning in October. EXHIBIT 1: Fed s forward guidance remains above the market s expectation. Median Fed Funds Projections (September 2017) 4% 3% Market Expectations (as of September 30, 2017) Fed Funds Target Rate Median Fed Funds Projection 2% 1% 0% Dec-15 Jun-16 Dec-16 Jun-17 Dec-17 Jun-18 Dec-18 Jun-19 Dec-19 Jun-20 Median Fed Funds Projection: the median rate outlook among the 16 FOMC members. Source: Federal Reserve and Bloomberg Barclays, as of Sep. 30,

3 THE FED STAYS ON ITS FAIRLY HAWKISH PATH The Fed had purchased the vast majority of these securities from 2008 to 2014 as part of its so-called quantitative easing (QE) efforts to stimulate the U.S. economy. Rather than selling bonds on the open market, the Fed plans to begin gradually reducing the rate at which it reinvests in maturing Treasury securities and mortgage-backed securities now on its books. To do so predictably, the Fed will set a cap that allows for a gradually increasing amount of balance-sheet runoff. For Treasury securities, for example, the Fed plans a runoff cap that begins at $6 billion per month and increases by that same amount every three months until the cap eventually reaches $30 billion, meaning that up to $30 billion of maturing securities will not be repurchased each month. The Fed plans a similar limit for U.S. agency debt and agency mortgage-backed securities, beginning at $4 billion per month and increasing by intervals of $4 billion every three months until it hits $20 billion per month (Exhibit 2). This long process of balance-sheet normalization essentially is quantitative easing in reverse. Just as QE flooded the system with cash and put downward pressure on money market rates relative to benchmarks, it is possible that the Fed s efforts to reduce its balance sheet could slightly benefit investors over time by contributing to higher market yields. We largely expect this process to go smoothly. The Fed will likely attempt to avoid anything akin to the taper tantrum of 2013, a period of surging yields attributable to the Fed s reduced bond purchases. EXHIBIT 2: It s a long road to balance-sheet normalization. Monthly Runoff Cap vs. Expected Maturities/Prepayments (millions) $80,000 $60,000 Treasury Maturities MBS Prepayments Treasury Cap MBS Cap $40,000 $20,000 $0 Aug-17 Dec-17 Apr-18 Aug-18 Dec-18 Apr-18 Aug-19 Dec-19 Apr-20 Aug-20 Dec-20 MBS: mortgage-backed securities. Source: U.S. Federal Reserve as of Sep. 30,

4 A debt ceiling impasse has been temporarily avoided We view President Donald Trump s recent agreement with congressional Democrats to temporarily suspend the U.S. government s debt ceiling until December 8th as a positive development for money markets. The two sides reached a pact early in September as part of a $15.25 billion bill that sought to aid victims of Hurricane Harvey, which made landfall in Texas in late August. Prior to the agreement, Congress had faced a mid-october deadline to raise the ceiling or face the likelihood of the U.S. government running out of borrowing capacity. We believe that suspending the debt ceiling may result in a better supply-demand balance for short-term government bonds in the near term. However, while the agreement to raise the debt ceiling essentially funds the government for roughly three months, it simply pushes back a deadline for Congress to vote to either increase or eliminate the ceiling before it again becomes binding. Due to the mechanics of the debt limit, the actual date that the limit becomes binding is likely to be pushed back to the spring/summer of No matter what happens as we approach year-end and the start of 2018, we believe our money market funds are well-positioned to accommodate any periods of market volatility that could arise from any delay by Congress in permanently addressing the debt ceiling. Fidelity s money market funds are well-positioned for higher rates We believe policy interest rates will continue to trend higher. The September FOMC meeting largely confirmed the Fed s expectations for three more rate hikes in 2018, in addition to the quarter-point hike expected at yearend This likely will continue the trend of higher rates that began 21 months ago. EXHIBIT 3: AUM trends slowly higher for Prime, Government and Ultrashort Bonds. Prime and Government MMF Relative to Ultrashort Bond Flows Index Value (Dec 31, 2016=100) Prime Government Ultrashort Bond December-16 April-17 August-17 See endnotes for fund definitions. Source: imoneynet, as of Sep. 30,

5 THE FED STAYS ON ITS FAIRLY HAWKISH PATH While the Fed slightly reduced its long-run rate outlook at its September meeting, removing nearly one full quarter-point rate hike from its long-term projection, this slightly dimmer view may not matter very much, given the number of Fed board governors set to be replaced in the coming months. The steady increase in market rates is driving liquidity into both money market and ultrashort bond funds. While government money market funds have yet to return to their prior peak after a sluggish first half, prime money market funds have grown by $66 billion year-to-date and may continue to benefit as corporate treasurers further segment liquidity. Any tax repatriation may also benefit the funds, as treasurers seek enhanced diversification and relatively higher rates versus bank-administered deposits (Exhibit 3). Fidelity s money market funds are positioned with short weighted-average maturities. Thus, we believe the funds are well-positioned in a market that has exhibited higher yields and fairly stable spreads (Exhibit 4), and are prepared for higher rates. Potential tax-code changes remain on the radar In September, President Trump outlined a proposal for U.S. tax reform that has potential impact for money market funds. For corporate taxes, items under consideration include lowering the statutory tax rate, allowing for the expensing of capital expenditures and/or the extension of bonus depreciation, as well as for making corporate interest expenses non-deductible. Additionally, plans for a territorial tax system and for repatriating cash held overseas by U.S. companies are under discussion. EXHIBIT 4: Yield spreads for Prime and Government MMFs remain stable. Yield and Yield Spread Comparison of Prime MMFs Versus Government MMFs Yield (%) 1.2 Government MMFs (left axis) Prime MMFs (left axis) 1.0 Spread (right axis) Spread (%) Oct-16 Dec-16 Feb-17 Apr-17 Jun-17 Aug-17 Oct Source: imoneynet, as of Sep. 30,

6 Although some of the repatriated cash may wash through domestic money market funds, survey data suggest that most of the repatriated cash ultimately will be used to reduce debt, repurchase shares, increase dividends, or enhance capital spending. As a result, the reduction in short-duration corporate issuance may further suppress credit spreads that already are tight by historical standards. President Trump s proposal is now being debated. Treasury Secretary Steven Mnuchin claims that the plan will boost GDP growth to an annual rate of 2.9% over the next 10 years, while also boosting government revenues. However, the Committee for a Responsible Federal Budget estimates that the framework will cut about $5.8 trillion in taxes over the decade and may add about $2.2 trillion in government debt. EXHIBIT 5: Enhanced supply pressures repo spreads wider. Overnight Repo vs. 1M Treasury Bill Spreads 2.0% Overnight Repo 1M Bill 1.5% 1.0% 0.5% 0.0% Sep-16 Dec-16 Mar-17 Jun-17 Sept-17 Source: Bloomberg Barclays, as of Sep. 30, Although the proposed tax overhaul still is in its early stages and may require significant modifications if it is to be passed by Congress, it remains on our radar. Supply-demand dynamics in the repurchase market are improving Overall, we believe money market supply dynamics are healthy, and have improved meaningfully for overnight Treasury/agency repurchase agreements (repos), which represent a significant portion of the allocations for many Fidelity government money market funds (Exhibit 5). Based on data released by the Office of Financial Research, dealer repo transactions in money market funds increased 139%, to $818 billion at the end of August, up from a low of $343 billion in June This largely is a result of banks from the United Kingdom, France, Japan, and Canada increasing their trading with money market funds. The added supply has helped to meet investor demand that rose dramatically following a migration of cash from prime money market funds into government money market funds, largely a response to money market reform legislation that took effect in October There also is a not-so-new player that may increasingly serve as a counterparty to money market funds in the repo market: FICC, or the Fixed Income Clearing Corporation. FICC s Sponsored Repo Services seeks to enhance bank balance-sheet efficiency by further promoting safety for participating funds. While the dollar amount of FICC Sponsored Repo Services for money market fund transactions in August remained relatively small, we believe the need for enhanced balance-sheet efficiency and risk mitigation may lead to a greater number of banks and funds using FICC as the legal counterparty for repo transactions in the future. This could further benefit the market s supply-demand dynamics going forward. 6

7 THE FED STAYS ON ITS FAIRLY HAWKISH PATH Authors Michael Morin, CFA l Director of Institutional Portfolio Management Michael Morin is director of money market institutional portfolio management in the Fixed Income division at Fidelity Investments. In this role, he is responsible for communicating portfolio strategy and positioning, designing customized liquidity-management solutions for institutional clients, and providing portfolio reviews. Kerry Pope, CFA l Institutional Portfolio Manager Kerry Pope is an institutional portfolio manager in the Fixed Income division at Fidelity Investments. In this role, he is responsible for communicating portfolio strategy and positioning, designing customized liquidity-management solutions for institutional clients, and providing portfolio reviews. Fidelity Shareholder Communications Director Mike Tarsala provided editorial direction. 7

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