Interest rates appear certain to rise on both sides of the Channel, with the market pricing three 0.25 per cent rises in Europe and the UK by the end of this year, 2.25 per cent to 2.50 per cent by the end of 2012 and 3.0 per cent by December 2013.
Jean-Claude Trichet, president of the European Central Bank (ECB), recently spoke of the “strong vigilance” necessary to deal with price pressures, which suggests the ECB will hike rates in April. The UK’s 0.5 per cent rate has now been unchanged since March 2009, but the consumer prices index measure of inflation rose to 4 per cent in January – well above the Bank’s 2 per cent medium-term target – which also points to an inevitable rise. Recent monthly Monetary Policy Committee meetings have been increasingly divided, and the balance could be thrown by Goldman Sachs economist Ben Broadbent, who replaces hawk Andrew Sentence in May.
Diverse Requirements
The situation in the eurozone is complicated, however, because the ECB must try to set a single policy for the region as a whole, but the different countries have diverse requirements. A series of small quarter per cent rate increases would push up borrowing costs in Ireland, Spain and Greece, and price Portugal out of the debt markets, while the merit in raising rates to deal with inflationary pressure are questionable when the major causes are rising prices in imported commodities and increases in indirect taxes.
“Every central Bank has a different mandate,” points out George Tsapouris, investment strategist, Coutts. “In the UK, it is about controlling inflation, while in the US it is more about promoting growth; and so the US will probably be the last to raise rates this time as it wants to first see unemployment falling. With Trichet making it clear the ECB will raise rates in April, this means short-term rates can now reflect expectation of higher rates across the UK, Eurozone and US.”
The Triple A benchmark is in line with the base rate so what tends to happen is that while some of that money is held in short positions, a proportion is held at three to six months and the overall return takes advantage of expectations and should outperform by 15-20 basis points. This will not be static but modifying as rates continue to move and because of funds’ high turnover, any future rises should be reflected relatively quickly.
Last to implement rises will be the US. The Taylor Rule, devised by Stanford economist John Taylor, suggests the Federal Reserve increases rates in times of high inflation, but only when employment figures are good. The labour market now appears to be strengthening with unemployment declining in 24 US states in January while payrolls increased in 35 states.
Redemptions
Rate increases will be a relief for the money market fund industry which has suffered redemptions as the rates on offer have been so low. Total assets in euro-denominated money market funds fell by 15 per cent last year, by E108bn to E624bn, as investors looked for a better return from long-term asset classes such as equities. Corporate Treasuries remain good clients, however, as many businesses have been recovering well and generating strong cash flows.
Money market funds must adapt quickly as the economic backdrop changes, or risk losing market share to more flexible money market instruments and higher-yielding products offered by commercial banks.
“Recent pressure on the Eonia (Euro OverNight Index Average) and uncertainty in the interbank market raised the case for variable rate positioning,” says BNP Paribas Investment Partners’s fixed income product specialist Xavier Gandon. “To prepare for this, BNP’s portfolios were on average 80 per cent invested in variable rate instruments at the end of January 2011. This enables our money market funds to offer a strong correlation between their performance and the return of the risk-free rate. Our exposure to interest rates is low and we can be confident in a market where we expect interest rates to increase in the coming weeks.”
Proactive management is as critical in the money market space as it is in active equity management. “People may view money market funds as boring because they are on the low end of the risk spectrum, but it is a challenging area from an investment standpoint,” says Joe Sarbinowski, global head of institutional cash sales for DB Advisors.
“There is zero tolerance for loss in these funds, and a lot of portfolio turnover, and diligence is required to get a balance between safety and performance. Whether it is a sovereign crisis, a credit issue, or how events in the Middle East are affecting credits, the manager must always be on guard and have robust processes,” he explains.
