Portfolio Manager Commentary
Overview, strategy, and outlook: As of November 30, 2017
Money market overview
When we last met, the House was teetering on the brink of approving a tax reform package, which it passed shortly after the month began. The House bill contains a combination of personal income tax and corporate tax rate and treatment changes, with hallmark provisions including, on the individual front, compressing the individual tax brackets from seven to four (with the top rate staying at 39.6%), eliminating personal exemptions, doubling the standard deduction, and sharply curtailing itemized deductions and, on the corporate front, lowering the corporate tax rate from 35% to 20% and imposing a one-time tax of 14% on overseas profits held in cash while those held in other forms would be taxed at 7%. Following this success, the Senate began hammering out its own version. By month-end, though not finalized, it was clear that the Senate’s bill, if passed, would vary significantly from the House’s version. This situation, though seeming to move at the same speed paint dries, had a relatively positive impact on markets and investor sentiment, being viewed as evidence that Congress and the president not only could get part of their agenda accomplished but also could pass legislation that is generally perceived to be positive for investors and the investing environment.
U.S. government sector
Yields on short-term U.S. government securities moved higher in November, reflecting growing expectations for positive developments from the two main drivers of rates: Federal Reserve (Fed) policy and the supply/demand equation. On the Fed front, consistently solid economic data, including stabilizing prices (suggesting inflation may be ready for a slow grind higher), has combined with unwavering Fed messaging to not only make a December rate hike a near certainty but also put further rate hikes in 2018 firmly on the table. The Treasury bill (T-bill) market’s embrace of the likely 0.25% rate hike in mid-December is reflected in the steady march higher in 3-month T-bill yields as the Fed meeting approaches. As shown in the chart below, term premia, as measured by the excess of the T-bill yield over the then-current rate on the Fed’s reverse repurchase agreement (RRP) program—currently at 1.00%—have increased earlier in the weeks leading into the potential rate hike than in the four previous tightening moves in this cycle, dating back to December 2015.
Excess of 3-month T-bill yields over RRP
Source: Bloomberg L.P.
The T-bill market appreciating the approaching hike to a greater degree than previous hikes could be due to several factors. First, it could reflect growing Fed credibility, a belief that the Fed will do what it has suggested it will, bolstered by economic data that has continued to be solid. Second, bringing us back to the supply/demand market dynamic, it may reflect the accumulated weight of a steady increase in T-bill issuance throughout the fall. As the chart below shows, the total amount of T-bills outstanding rose $252 billion from June 30, 2017, to the end of November 2017, providing a supply shock that, all other things being equal, may push yields higher.
Sources: Bloomberg L.P., U.S. Treasury, Wells Capital Management Inc.
A good indication of the impact of the larger supply on the market has been a reduction in the amount of money placed with the Fed in its RRP program, displayed in the chart below. Over the period from the effective date of the change in money market fund (MMF) regulation on October 14, 2016, through October 31, 2017, the average daily RRP take-up was $161 billion. That regulatory change resulted in about $1 trillion moving from prime to government money market funds, adding significant demand to the market for short-maturity government securities, including the RRP. For the month of November 2017, the daily RRP average fell to just $52 billion. It seems likely that higher T-bill yields enticed investors to move out of the RRP into T-bills or other similarly priced government securities, such as agency discount notes.
Fed RRP volume (with three-month average)
Sources: Federal Reserve Bank, Bloomberg L.P.
In addition to the T-bills that have already been issued, investors are keenly anticipating additional supply increases. This reflects a number of factors, but the most immediate impetus was provided by the Treasury’s expression in its Quarterly Refunding Statement on November 1 of its desire to meet any funding shortfalls by issuing additional T-bills. The Treasury said:
"Based on current fiscal forecasts, Treasury intends to maintain coupon issuance sizes at current levels over the upcoming quarter. Treasury plans to address changes in any seasonal borrowing needs over the next quarter through changes in regular bill auction sizes and/or cash management bills."
We mentioned above the dual drivers of short-term interest rates: Fed policy and the supply/demand equation. If you think of each of them as rivers, say the Missouri River and the Illinois River, each one joining the Mississippi River just north of St. Louis, a stronger flow in either of the source rivers makes the Mississippi stronger. In this case, not only are both rivers surging, with strong expectations for Fed action and T-bill supply having already grown, but the prospect of further T-bill supply, perhaps resulting from the Treasury’s increased funding needs due to the Fed’s balance-sheet reduction, potential tax cuts, or both, is like rain falling in the headwaters, with that water winding its way to the Mississippi soon enough.
We continue to find ourselves in a market environment where negative headlines or events cause risk assets to temporarily widen (sell off), only to ratchet tighter as the backdrop of improving economic fundamentals and progress in Washington provides support to risk assets. Equities—as a proxy for risk assets—briefly sold off earlier this month as the tax plan that was being debated in Congress appeared to be stalling, only to quickly rebound once headway on the plan was announced, taking the Dow Jones Industrial Average to all-time highs. The same can be said for credit spreads, as those in high-yield and investment-grade credits widened midmonth, only to close the month at or near tight levels for the year.
Even though we experienced event-driven spikes in volatility, the overall level of volatility continued to trend in a very low and narrow range during the month and, really, throughout the year. The Chicago Board Options Exchange Volatility Index (VIX)1, an index reflecting the market’s estimate of the S&P 500 Index’s future volatility, ranged from a high (most volatile measure) of 17.28 to a low of 8.56. In comparison, six years ago, the 2011 range was from a high of 48.00 to a low of 14.27. During these periods of low volatility and a positive credit environment, the Fed and expectations of future Fed policy largely have been dictating money market rates. Since the financial crisis, the Fed and other central banks have kept target rates low and have used their balance sheets to provide support for market prices and to attempt to fuel economic growth. However, as these banks begin the slow unwind of their accommodative policies and remove the floor supporting risk assets, it appears markets are now beginning to anticipate that changes to fiscal policy may possibly fill this gap and may allow the private sector (whether subsidized or not) to take over. This would partially explain the reaction function for risk assets over the course of the month as fiscal policies, such as the tax bill working its way through Congress, are playing a greater role in markets and in maintaining a positive credit environment.
The benign credit environment in risk assets has put the focus of prime funds squarely on the effects of Fed policy, especially with a sharply curtailed supply pipeline. Last month, we mentioned that we anticipated that LIBOR (London Interbank Offered Rate) would reset higher by about 2 basis points (bps; 100 bps equal 1.00%) a week as we approach the Federal Open Market Committee (FOMC) meeting in mid-December. And indeed, three-month LIBOR not only has methodically marched higher but also has exceeded our expectations, increasing 11 bps during November. At this pace, it may reach just under 1.55% at the time of the predicted 25-bp tightening at the December 14 Fed meeting. That may place three-month LIBOR just above the new upper band of the Fed target range of 1.25% to 1.50%. (Fed RRP is expected to be at the lower band of 1.25%.)
Counterbalancing this relative attractiveness, though, is the challenging supply picture as we approach year-end. Non-seasonally-adjusted commercial paper outstanding decreased by $10 billion in November. The drop was shared by all sectors: Nonfinancial and financial papers both were down about $3 billion, while the asset-backed sector was down just under $5 billion. About 51% of the commercial paper outstanding has been placed over the turn of the year, into 2018. Because of the changes to bank regulatory liquidity rules several years ago, that placement is further into the new year than had been seen in years past. As shown on the graph below, year-end 2016 and 2017 show more maturities being placed into February and early March, as opposed to the first few weeks of January shown at year-end 2015.
Weekly pattern of commercial paper maturing after December 31
Source: Federal Reserve
For prime money market funds, the gradual pace of Fed tightening has enabled managers of those assets to opportunistically extend weighted average maturities (WAMs)2 and weighted average lives (WALs)3 to take advantage of what yield pickup there is from extension out the curve. The average maturity for institutional prime funds has hovered in the mid-20s for the past several months. Our funds’ WAMs have been slightly lower at around 20 days recently (with WALs closer to 55 days) in an effort to maintain increased amounts of liquidity and to be in a position to more quickly capture the effects of future rate hikes. In this environment, we continue to construct high-quality portfolios that are focused on liquidity while opportunistically purchasing floating-rate notes as we seek to incrementally increase yields.
Wells Fargo FNAV money market fund NAVs
Source: Wells Fargo Funds
Wells Fargo FNAV money market fund weekly liquid assets
Source: Wells Fargo Funds
All eyes in the financial markets were trained on Washington, D.C., where members of the House and the Senate continued to hammer away at their own versions of comprehensive tax reform legislation in the hopes of presenting a final bill that can be signed into law by the president by year-end. Given the wide-ranging scope of the proposed legislation, the potential for significant impacts for both issuers and investors in various asset classes and strategies across the globe is substantial, to say the least. Naturally, participants in the municipal markets are particularly attentive to any policy changes that may affect the long-term relative attractiveness of tax-exempt securities. But, despite the potential for historical shifts in marginal tax rates, eligible deductions, and other tax-liability calculations being discussed, the most immediate concern for the municipal markets in the month of November pertained to the potential elimination of the exemption for private activity bonds (PABs) and advanced refunding bonds at year-end.
During the month of November, the municipal market adopted a defensive tone as the potential elimination of these important structures resulted in a surge in issuance by borrowers seeking to beat the perceived year-end cutoff. While the bulk of this activity and market reaction occurred just beyond the municipal money market space, the combination of a strong acceleration in supply and a looming rate hike by the FOMC exerted upward pressure on rates in the short end as well. The Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index4 rose from 0.92% at the end of October to 0.97% by the end of November, its highest level since December 2008. The municipal money market yield curve steepened as longer-dated paper rapidly responded to supply pressures by rising to multiyear highs as well. Top-rated one-year notes closed out the month at 1.30%, up from 1.08% the previous month. The sudden backup in rates has resulted in favorable tax-exempt to taxable ratios throughout the front end of the curve. The SIFMA to 1-week LIBOR ratio rose to 0.80% by month-end, up from 0.76% the previous month.
Despite the potential challenges presented by the current tax reform proposals, it is important to note that both the House and the Senate bills would retain the tax-exempt status for all current tax-exempt bonds. Both versions also would preserve the tax-exempt status for traditional municipal issuers, such as states and local issuers, going forward. However, the House and the Senate bills diverge with respect to PABs, with the former eliminating their tax-exempt eligibility beginning in 2018 while the latter would actually improve their attractiveness as a financing mechanism for much-needed essential service and infrastructure projects. It remains to be seen what the final bill will look like.
With so much at stake, many issuers are not taking chances and will continue to front-load new issues until a final bill is passed. Accordingly, we anticipate that volume should remain robust through year-end, which should continue to put upward pressure on rates in the municipal money market space in the short term. Ultimately, we remain optimistic that municipal securities should remain attractive for both issuers and investors alike—whatever the outcome of the new tax reform legislation. In the meantime, we continued to position our portfolios with a strong emphasis on daily and weekly liquidity in order to take advantage of favorable ratios in the short end while preparing for higher absolute levels, courtesy of the FOMC, in the coming weeks.
On the horizon
By the time this goes to press, the Senate will have taken action and either will have passed or will have been unable to pass its own version of tax reform. Odds seem to be leaning toward passage, and if it achieves that goal, there are likely to be significant differences from the House version. If that’s the case, one path would involve the perceived easy or quickest route to enactment, in which the House abandons its bill and votes to pass the Senate bill without amendment. Given the differences being discussed at month-end, this seems unlikely. The alternative would be that the bills go through Congress’ reconciliation process in which, at its simplest, changes are made in each committee until one bill is consolidated, at which point it is voted on by both houses. In either case, it is entirely possible that Congress still could achieve its goal of passing this legislation before year-end.
And that would be a good outcome, as one significant deadline that has the potential to affect both money markets and the Fed is looming on the near horizon: December 8. On that date, without further action, two things will happen: The debt ceiling that had been lifted will once again be in effect, and the government will be unable to fund its day-to-day operations by issuing more debt. The Treasury will be able to exercise its extraordinary measures to keep the government running without exceeding the debt ceiling, but eventually Congress will need to act to ensure a government shutdown either does not occur or is very short-lived and to resolve the debt-ceiling bind. Pile all of this on at the end of the month and it makes for a very interesting year-end.
We wish you and yours a very happy holiday season and a prosperous new year!
Rates for sample investment instruments—Current month-end % (November 2017)
|Sector||1 day||1 week||1 month||2 month||3 month||6 month||12 month||Wells Fargo Fund||7 day current yield|
|U.S. Treasury repos||1.03||1.03||–||–||–||–||–||Cash Investment*–Select shares||1.27|
|Fed reverse repo rate||1.00||–||–||–||–||–||–||Heritage*-Select shares||1.25|
|U.S. Treasury bills||–||–||1.12||1.14||1.26||1.44||1.61||Municipal Cash Mgmt*–Inst'l shares||0.86|
|Agency discount notes||1.00||1.02||1.12||1.20||1.26||1.37||1.48|
|Asset-backed commercial paper||1.17||1.23||1.38||1.48||1.53||1.70||–||Treasury Plus**-Inst'l shares||0.94|
|Dealer commercial paper||1.10||1.11||1.19||1.27||1.34||1.51||–||100% Treasury**-Inst'l shares||0.95|
Sources: Bloomberg L.P., Wells Capital Management, Inc., and Wells Fargo Funds
Figures quoted represent past performance, which is no guarantee of future results, and do not reflect taxes that a shareholder may pay on a fund. Yields will fluctuate. Current performance may be lower or higher than the performance data quoted and assumes the reinvestment of dividends and capital gains. Current month-end performance is available at the funds’ website, wellsfargofunds.com.
Money market funds are sold without a front-end sales charge or contingent deferred sales charge. Other fees and expenses apply to an investment in the fund and are described in the fund’s current prospectus.
The manager has contractually committed to certain fee waivers and/or expense reimbursements. Brokerage commissions, stamp duty fees, interest, taxes, acquired fund fees and expenses, and extraordinary expenses are excluded from the cap. Without these reductions, the seven-day current yield for the Institutional Class of the Cash Investment Money Market Fund, Heritage Money Market Fund, Municipal Cash Management Money Market Fund, Government Money Market Fund, Treasury Plus Money Market Fund, and 100% Treasury Money Market Fund would have been 1.04%, 1.01%, 0.71%, 0.79%, 0.80%, and 0.54%, respectively, and the total returns would have been lower. The cap may be increased or the commitment to maintain the cap may be terminated only with the approval of the Board of Trustees. The expense ratio paid by an investor is the net expense ratio or the total annual fund operating expense after fee waivers, as stated in the prospectus.
1. The CBOE Volatility Index® (VIX®) is a popular measure of the implied volatility of S&P 500 Index options. It represents one measure of the market’s expectation of stock market volatility over the next 30-day period. You cannot invest directly in an index.
2. Weighted average maturity (WAM): An average of the effective maturities of all securities held in the portfolio, weighted by each security’s percentage of total investments. The maturity of a portfolio security is the period remaining until the date on which the principal amount is unconditionally required to be paid, or in the case of a security called for redemption, the date on which the redemption payment is unconditionally required to be made. WAM calculations allow for the maturities of certain securities with demand features or periodic interest-rate resets to be shortened. WAM is a way to measure a fund’s sensitivity to potential interest-rate changes. WAM is subject to change and may have changed since the date specified.
3. Weighted average life (WAL): An average of the final maturities of all securities held in the portfolio, weighted by their percentage of total investments. The maturity of a portfolio security is the period remaining until the date on which the principal amount is unconditionally required to be paid, or in the case of a security called for redemption, the date on which the redemption payment is unconditionally required to be made. The calculation of WAL allows for the maturities of certain securities with demand features to be shortened but, unlike the calculation of WAM, does not allow shortening of the maturities of certain securities with periodic interest-rate resets. WAL is a way to measure a fund’s potential sensitivity to credit spread changes. WAL is subject to change and may have changed since the date specified.
4.The SIFMA Municipal Swap Index is a seven-day high-grade market index composed of tax-exempt variable-rate demand obligations with certain characteristics. The index is calculated and published by Bloomberg. The index is overseen by SIFMA’s Municipal Swap Index Committee. You cannot invest directly in an index.
*For floating NAV money market funds: You could lose money by investing in the fund. Because the share price of the fund will fluctuate, when you sell your shares they may be worth more or less than what you originally paid for them. The fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time.
For retail money market funds: You could lose money by investing in the fund. Although the fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time.
**For government money market funds: You could lose money by investing in the fund. Although the fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time.
For the municipal money market funds, a portion of the fund’s income may be subject to federal, state, and/or local income taxes or the Alternative Minimum Tax (AMT). Any capital gains distributions may be taxable. For the government money market funds, the U.S. government guarantee applies to certain underlying securities and not to shares of the fund.
The views expressed and any forward-looking statements are as of 11-30-17 and are those of the fund managers and the Money Market team at Wells Capital Management Inc., subadvisor to the Wells Fargo Money Market Funds, and Wells Fargo Funds Management, LLC. Discussions of individual securities, the markets generally, or any Wells Fargo Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.
Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For a current prospectus and, if available, a summary prospectus, containing this and other information, visit wellsfargofunds.com. Read it carefully before investing.