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Cash has further to run

Christopher Ellinger & Izzi Halewood

Christopher Ellinger & Izzi Halewood - Portfolio Manager & Associate Investment Director, Fixed Income

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As interest rates are expected to stay higher for longer, so should the relative attractiveness of cash in investment portfolios.

Highlights

  • Investors likely overestimated the speed and scale of rate cuts earlier this year. Expectations dwindled from six or more 25-basis-point cuts at the start of the year to just two in April for the Fed.
  • Central banks may be struggling to lower interest rates amid stickier inflation. In addition, resilient economic growth supports prolonged tight financial conditions.
  • In a ‘higher for longer’ interest rate environment, money market funds offer additional stability, cementing their critical role in the investment portfolio.

Expectations for interest rate cuts dampening

Just as investors underestimated the pace and scale of interest rate hikes when the US Federal Reserve (the Fed) started its cycle, they appear to have overestimated the speed of rate cuts this year. In January, the market was pricing in just over six rate cuts - at 25 basis points each - for the US in 2024. The picture was similar in the UK and Europe, too. As of April, expectations have fallen to two rate cuts (see the chart below), with some market commentators suggesting that a rate cut may not even be on the cards at all this year in the US.

What the Fed does will likely influence other central banks, even as US and European economic and inflation data appear to be diverging. Weaker growth and softening inflation expectations may provide the European Central Bank (ECB) and the Bank of England (BoE) more scope to decrease borrowing costs.

As much as central bankers, including the ECB’s President Christine Lagarde, play down the impact of exchange rates in interest rate decisions, it is certainly a consideration. If the ECB and the BoE cut too much relative to the Fed, it could weaken the euro and sterling, respectively, again stoking inflation. Indeed, interest rate predictions for the ECB have also been tempered to three rate cuts from six or more in January. Likewise, the Bank of England is now expected to deliver around two rate cuts, again, from six or more during the same time.

Number of interest rate cuts priced in for 2024, as of April

Central bank policy rates over the last few decades

Source: Fidelity International, Bloomberg, data as of April 23, 2024. Market pricing is derived using OIS forward curves. Note: Y-axis denotes the number and direction of interest rate movement, with each rate cut representing a quarter percentage-point decrease in base interest rates.

Since 2022, when the Fed, the ECB and the BoE began raising rates, investors have been better incentivised to invest in money market funds (MMFs), which invest in cash equivalents and ultra-short term debt securities, because MMFs deliver a return in line with central bank rates. In 2023, for US dollar MMFs, that equated to a total return of around 5%. This is all whilst taking very low duration and credit risk. As a result, European-domiciled MMFs grew by an estimated 12.4% in 2023, compared with an increase of 2.8% in 2022, according to data from the ECB.1

Before the sharp repricing of rate cut expectations at the start of this year, investors were beginning to extend maturities and take more duration risk in an attempt to lock in yields at attractive levels. However, now that rate cut expectations may have proven too aggressive, given stickier inflation and better economic performance, there is less need for investors to increase risk in their portfolios to generate the same returns. These ever-changing expectations may introduce unwanted portfolio volatility for longer duration and lower-rated strategies, making the case for keeping a higher allocation to MMFs.

What has driven the sharp repricing in yields?

Inflation is one of the main reasons central banks are unable to lower interest rates quicker. And here, some key drivers are still exerting upward pressure. First, geopolitical tensions such as those in the Middle East and Ukraine could increase inflation risks. Following an Israeli attack on a diplomatic building next to the Iranian embassy in Syria, oil prices climbed to a six-month high at US$92 a barrel for global benchmark Brent crude. Second, in the US, rents have been the key driver of high core inflation numbers, while parts of services inflation that reset prices once per year all came in higher than expected, too.

Additionally, economic growth has been resilient (more so in the US than other markets), supporting a longer period of tighter financial conditions. According to the International Monetary Fund, the US economy is expected to grow by 2.1% this year, twice as fast as the European economy, which is set to increase by 0.9%. Unemployment has also been steady at 3.8% in March for the US and about 6% in February for the European Union.2 Global manufacturing is also up. The JP Morgan Global Manufacturing purchasing managers’ index, which gauges operational conditions, rose to 50.6 in March from 50.3 the previous month. Furthermore, the three underlying sub-indices measuring new orders, output, and employment also expanded in March, providing further evidence of the momentum building in global manufacturing.

The changing role of cash

Of course, interest rate trends may not play out as expected, once again wrongfooting investors. Take the period between March 2022 and July 2023. In January 2022, markets estimated between three and four quarter percentage-point interest rate increases for the year.3 By the end of July 2023, the Fed had increased interest rates 11 times in one of the fastest rate hikes in decades (see the chart below). The year was marked by cash outperforming most other asset classes.

Central bank policy rates over the last few decades

Central bank policy rates over the last few decades

Source: Fidelity International, Bloomberg, data as of April 23, 2024.

Market dynamics are more difficult to predict and can quickly turn against market expectations. In this environment, the role of MMFs in an investment portfolio goes beyond its traditional purpose of providing liquidity and capital preservation. They can provide the necessary portfolio ballast when volatility catches investors off guard.

In the previous era of ultralow interest rates, there was a high opportunity cost for that protection. But this has changed - the ‘higher for longer’ setting delivers an attractive premium for investors holding cash. The yields on cash assets are still on a par with, if not higher than, some parts of the fixed-income universe with relatively higher risk. Therefore, MMFs should continue to play a leading role in the portfolio.

1Total Assets/Liabilities reported by MMFs in the euro area (stocks), Euro area (changing composition), Quarterly”, ECB, Feb. 16, 2024.
2 Data provided by the US Bureau of Labor Statistics, the Office for National Statistics in the UK, and Eurostat, the statistical office of the European Union.
3 Indradip Ghosh and Prerana Bhat, “Fed to raise rates three times this year to tame unruly inflation: Reuters poll”, Reuters, Jan. 20, 2022.

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