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Dash for cash - The benefits of money market funds as interest rate peak nears
PRO 13. Juni 2023
Central banks have been raising interest rates at a pace that is among the fastest in recent history, a trend that has propelled money market funds (MMFs) to the top of the list for many investors seeking attractive risk-adjusted returns.
Compared with bank deposits, for example, MMFs are typically able to increase their yields at a faster pace, keeping up with the rise in central bank rates more quickly. Money market strategies can also provide downside protection at the end of central bank hiking cycles. When bond yields reach their peaks - as we think they are close to doing - extending the term of the paper in MMFs takes advantage of the higher yields on offer.
In the following, we discuss the outlook for interest rates, how it may impact money market strategies, and what investors can do to optimise their allocation.
To hike or not to hike
The market consensus is that the central banks will need to cut interest rates as soon as later this year (see Figure 1). Yet inflation also remains decidedly stubborn. Despite some signs of softening, inflation still exceeds key central bank targets. In the UK, wage growth, energy costs and ongoing supply chain challenges have contributed to persistent inflationary pressures. And given recent upside data surprises, the Bank of England may be further from the interest rate peak than expected.
Figure 1: Interest rate hiking cycles, Bank of England vs. the Fed
Sources: Fidelity International, Bloomberg, data as of March 31, 2023. For illustration purposes only.
Earlier this month, US Federal Reserve Chairman Jerome Powell said he does not expect inflation to decline quickly, signalling resistance against the market consensus. We believe it would have to be a severe economic recession for the Fed to begin cutting interest rates before the end of the year, as is currently priced in by the forward markets. Therefore, we believe, interest rates will remain ‘higher for longer’. This is inherently positive for MMFs, where yields and total returns are driven for the most part by central bank rates. A higher-for-longer interest rate trajectory could potentially yield 4.5% to 5% for MMFs in US-dollar terms in the next three, six and 12 months.
In this elevated interest rate environment, MMFs will likely remain attractive from a risk-adjusted return perspective relative to other asset classes, including equities. Take the spread between the three-month US dollar London Inter-Bank Offered Rate (Libor) and the S&P 500 equity dividend yield, which is the largest since the 2007-2008 global financial crisis (GFC). From this perspective, investors might receive a higher income stream from US-dollar MMFs than owning US equities while taking a fraction of the risk (see Figure 2).
While we do not believe interest rate trends will reverse anytime soon, even if they eventually fall, MMFs have some key advantages. Relative to bank deposit rates, yields in MMFs may stay elevated for longer as central banks cut rates. This is because money market strategies can extend the maturity of the instruments held in the portfolio to increase the term premium.
Figure 2: Money market yield minus equity dividend yield, USD
Sources: Fidelity International, Bloomberg, data as of March 31, 2023. Money market yield = USD Libor. Equity dividend yield = S&P 500. Past performance is not a reliable indicator of future returns.
Risk controls
No matter which direction interest rates are heading, however, there are active decisions investors can take to manage downside risk more effectively. Money markets traditionally have very little exposure to interest rate or credit risk. However, a robust, disciplined, and independent credit research process is a critical foundation for building a money market strategy. For example, our proprietary research covers more than 900 issuers based on a combination of quantitative and qualitative assessments alongside market factors to build an approved issuer list with a minimum rating of A and A2 by S&P and Moody’s, respectively.
Sustainably liquid
Increasingly, an important consideration when assessing money market strategies is how environmental, social and governance (ESG) characteristics influence outcomes. Although the securities within a money market strategy tend to be short term in nature, long-term sustainability improvements are material because the same issuers often refinance or issue a series of short-term debts.
To assess ESG risk more granularly, an effective ESG engagement strategy that encompasses analysts across asset classes and regions is needed. In 2022, for example, Fidelity International conducted 1,464 engagements with more than 1,100 issuers, focusing on measurable improvements, both directly and in collaboration with other stakeholders. These engagement activities help inform investment decisions.
A safer harbour
Recent central bank action has propelled MMFs to the top of the list for many investors seeking attractive risk-adjusted returns with relatively low volatility, low interest-rate sensitivity, and capital preservation potential. Just as MMFs provided investors with a way to quickly benefit from rising interest rates, they may also help protect yield as policymakers slow or reverse course. In our view, money market strategies remain a safer harbour amid higher market uncertainty, particularly over the direction of central bank policies.
Risk warnings
- The value of investments and the income from them can go down as well as up, so clients/you may get back less than the amount invested.
- Past performance is no reliable indicator for future returns.
- Foreign currency investments are subject to exchange rate fluctuations.
- Investors should note that the views expressed may no longer be current and may have already been acted upon.
- Please refer to the Prospectus and KID of a fund before making any final investment decisions. The investment concerns the acquisition of units or shares in a fund and not in a given underlying asset owned by the fund.
- An investment in a money market fund is different from an investment in deposits, as the principal invested in an money market fund is capable of fluctuation. Fidelity’s money market funds do not rely on external support for guaranteeing the liquidity of the money market funds or stabilising the NAV per unit or share. An investment in a money market fund is not guaranteed.
- Money market instruments: The investment policy of these funds means they can be more than 35% invested in transferable securities and money market instruments issued or guaranteed by an EEA State, one or more of its local authorities, a third country or a public international body to which one or more EEA States belongs.
- Bond investments: These funds invest in bonds whose price is influenced by movements in interest rates, changes in the credit rating of bond issuers, and other factors such as inflation and market dynamics. In general, as interest rates rise the price of a bond will fall. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may, therefore, vary between different government issuers as well as between different corporate issuers.
- Corporate bonds: Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds.
- Other: Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Investors should note that the views expressed may no longer be current and may have already been acted upon.
- ESG: For funds promoting environmental and/or social characteristics, the Investment Manager’s focus lies on securities of issuers which maintain sustainable characteristics, which may affect the funds’ investment performance favourably or unfavourably in comparison to similar funds without such focus. The sustainable characteristics of securities may change over time.
Important Information
This is a marketing communication. This information must not be reproduced or circulated without prior permission. This information is intended for professional clients only and not a suitable basis for the general public or private investors.
Fidelity only offers information on products and services and does not provide investment advice based on individual circumstances, other than when specifically stipulated by an appropriately authorised firm, in a formal communication with the client.
Fidelity International refers to the group of companies which form the global investment management organisation that provides information on products and services in designated jurisdictions outside of North America. This communication is not directed at and must not be acted upon by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. It is your responsibility to ensure that any service, security, investment, fund or product outlined is available in your jurisdiction before any approach is made to Fidelity International.
Unless otherwise stated all products and services are provided by Fidelity International, and all views expressed are those of Fidelity International. The views expressed are as of the date of publication and are subject to change without notice. Fidelity, Fidelity International, the Fidelity International logo and F symbol are registered trademarks of FIL Limited.
This material may contain content from third parties which is supplied by companies that are not affiliated with any Fidelity entity (Third-Party Content). Fidelity has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. Fidelity International is not responsible for any errors or omissions relating to specific information provided by third parties.
Reference in this document to specific securities should not be interpreted as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The research and analysis used in this documentation is gathered by Fidelity for its use as an investment manager and may have already been acted upon for its own purposes. This material was created by Fidelity International.
For German Wholesale clients issued by FIL Investment Services GmbH, Kastanienhöhe 1, 61476 Kronberg im Taunus.
For German Institutional clients issued by FIL (Luxembourg) S.A., 2a, rue Albert Borschette BP 2174 L-1021 Luxembourg.
For German Pension clients issued by FIL Finance Services GmbH, Kastanienhöhe 1, 61476 Kronberg im Taunus.
Investors/ potential investors can obtain information on their respective rights regarding complaints and litigation in English here: Complaints handling policy (fidelity.lu) and in German here: Beschwerdemanagement (fidelity.de).
The information above includes disclosure requirements of the fund’s management company according to Regulation (EU) 2019/1156.
Unless stated differently, information dated as of May 2023.
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