The next 12 months will see further strength in the dollar and a continued flight out of prime money market funds the government funds. That’s the view of the head of PIMCO’s short-term funding desk, who shared in a webinar the asset manager’s key forecasts and investment strategy.
Managing director Jerome Schneider started out the presentation by emphasizing the importance of macro economic variables and how they impact central bank policy decisions. He also highlighted some of the demographic trends, gross domestic product (GDP) growth, and other key factors that are impacting the global economy. He noted that the US has led the charge on the growth front, resulting in the Fed eliminating monetary stimulus and taking early measures to stem inflation, which diverges sharply from the paths pursued by central banks in Europe and Japan.
As a result, demand for US dollars (USDs) is bound to increase, fueling the buck’s upward trajectory. Asked just how much stronger the USD is likely to get, Mr. Schneider said, “Looking over the next year or so, it would not be out of the ordinary if there is at least at 2% to 4% appreciation in the dollar,” adding that it won’t be in a “straight line” as the market digests a wide range of data.
Mr. Schneider noted the Fed’s promise that its rate decisions will be data driven, but that data now extends beyond the central bank’s traditional pillars of job creation and inflation. “A third pillar introduced last fall is the global financial condition, so it will be careful not to upset the global growth trend,” Mr. Schneider said, adding that while important to consider, global growth appears to be the least important factor in the impacting the Fed’s decisions.
Change in strategy
The Fed’s approach to raising rates has also changed somewhat, another factor to monitor, Mr. Schneider said. Traditionally, it has announced plans to raise rates to level Y from level X. Now, it has instead created a band where it’s going to target a rate quarterly. The upper band, known as interest on excess reserves, currently rests at 50 basis points (it was at 25 bps before the December hike). The lower band, known as the reverse repo facility (RRP), is the rate at which the Fed looks to loan collateral to and borrow cash from eligible counterparties such as banks and money market funds.
“The ideas is that the corridor, between 25 bps and 50 bps currently, will give a target range for where things like Fed funds and other short-term investments should trade,” Mr. Schneider said. However, the complication is that the RRP is not a “hard floor,” so some short-term financial instruments may trade below that floor—T-bills, in fact, continue to trade slightly below it. That may raise concerns at the Fed about the efficacy of this strategy, perhaps resulting in more deliberation before hiking rates again.
The T-bill rate is likely to stay below the lower band, Schneider said, in part because new rules impacting money market funds (MMFs) have prompted a shift away from prime MMFs to those investing only in government securities. He noted that new regulations have also made institutional deposits less welcomed by banks.
PIMCO estimates $175 billion has shifted into government MMFs and away from prime funds. Responding to another webinar participant’s query about the final tally for the shift, Mr. Schneider said PIMCO anticipates it could be between $400 billion to $600 billion in total. He added that another $100 billion to $200 billion will move out of government MMFs to alternative short-term investments.
Time for tiers
With so many factors pointing to virtually no returns from short-term securities, PIMCO takes a tiered approach to asset management. It identifies the level of assets it requires to be available on a same day basis to determine the size of the first tier, followed by its intermediate and long-term obligations to determine the second and third tiers of its portfolios.
“We manage [our portfolios] so we don’t have too much cash sitting around [but not] too little to meet unexpected obligations,” Mr. Schneider said, which provides returns that are multiples of investing directly in only short-term assets.
Asset returns are bolstered by the asset manager’s focus on credit, rather than seeking to identify where rates are headed, Mr. Schneider said. For example, PIMCO’s analysts look for investment managers looking to raise cash by selling assets with the shortest time left before reaching maturity, providing significantly higher returns than Treasury bonds and minimal risk.
“Given our in-house credit research, we can identify those liquidity premiums and capture them in our portfolios,” Mr. Schneider said. “We can be defensive managing liquidity and offensive putting capital to work where we think we can get those robust liquidity premiums.”