Wall Street enters risk-off mode! $8 trillion money market funds urgently shorten duration

Source: Jinse Finance

Since mid-May, US money market funds have significantly shortened the duration of their holdings. Data from Crane Data LLC shows that the weighted average maturity of these funds' holdings has dropped from 45 days to 40 days, reflecting that fund managers are reducing exposure even to assets with minor interest rate risks and are allocating more capital to ultra-short-term instruments.

In terms of specific allocation, fund managers have increased investments in overnight repo agreements and short-term securities, while also raising the proportion of floating-rate agency bonds and floating-rate US Treasuries. Despite the government’s continuous ramp-up of T-bill issuance, money market funds’ exposure to T-bills has still seen a slight decline.

This adjustment comes amid rising uncertainty about the Federal Reserve’s policy path and near-term interest rate outlook. International oil prices have surged, and Fed Chairman Waller’s hawkish tone once prompted traders to price in the possibility of a rate hike as early as this month. However, two tame inflation reports last week have made the policy outlook harder to predict, leading the market to reassess related bets.

In this environment, money market funds managing more than $8 trillion are more inclined to hold securities maturing, rolling over, or resetting their rates within weeks, in order to retain flexibility to reinvest at higher yields if rates rise again. Deborah Cunningham, Chief Investment Officer for Global Liquidity Markets at Federated Hermes, commented: "You need to keep sufficient liquidity to capture better investment opportunities ahead, so you’ll want those weighted average maturities to come down a bit."

Fund managers’ caution toward interest rate risk is also related to their experience in early 2022. At that time, right before the Federal Reserve began one of its most aggressive tightening cycles in decades, some fund managers were caught off-guard holding longer-term assets; this experience has made them even less willing to lengthen duration when the policy outlook is unclear.

From a flows perspective, repo agreements remain one of the core destinations. At the Crane money fund symposium last month, Geoff Gibbs, Managing Director at DWS Group, said that for most of this year, they have allocated about half their portfolio to repos and expect this structure to remain, especially now that rate hike expectations are factored into the outlook. Crane Data shows that in June, money market fund allocations to repos increased by about $36 billion, bringing the total to roughly $1.89 trillion.

The allure of floating-rate bonds is also rising. According to Wells Fargo Bank strategists Angelo Manolatos and Francis Brown, funds have further increased holdings of these assets; in June, money market fund holdings of US Treasury floating-rate notes rose to a record $523 billion. This suggests fund managers aim to capitalize on the high yields of 3-month T-bills without extending duration.

The increased supply of agency debt aligns with these portfolio shifts. Data from the Federal Home Loan Banks (FHLB) finance office shows that outstanding FHLB debt has grown by about $180 billion so far this year, with roughly $140 billion of that being floating-rate bonds. Over the same period, overall money market fund agency debt holdings increased by about $195 billion.

In contrast, although US T-bill supply continues to expand, there hasn't been a corresponding increase in allocations. On the contrary, futures money market fund holdings of T-bills fell by nearly $105 billion last month.

For future trends, several industry experts still expect durations to shorten further. Cunningham said that as the Federal Reserve prioritizes bringing inflation back to the target level, she expects weighted average maturities to drop further.

Manolatos said: “Given that the possibility of a rate hike in September still exists, and there have been plenty of hawkish comments from the Fed about potential hikes, money market funds will likely continue to shorten their weighted average maturities step by step starting now. For fund managers, unless absolutely necessary, the bar is quite high to do anything other than put excess cash into repos or floating-rate bonds.”