Portfolio Manager Commentary
Overview, strategy, and outlook: As of June 30, 2018
Money market overview
As expected, the Federal Open Market Committee (FOMC) raised its target rate 25 basis points (bps; 100 bps equals 1.00%) to a range of 1.75% to 2.00% after the June 13 meeting. The corresponding statement reflected the view that the economy continues to expand and inflation would remain symmetrical around its 2% threshold over the medium term. Risks to the economic outlook appear roughly balanced.
In addition, the FOMC delivered on the idea first floated in the May minutes by raising interest on excess reserves (IOER) by only 20 bps to 1.95%. As you may recall, the FOMC proposed, and now implemented, the IOER adjustment as a small technical realignment of the IOER rate relative to the top of the target range for the federal funds rate. The objective for this adjustment is to keep the federal funds effective (FFE) rate comfortably within the target rate range of 1.75% to 2.00%. Prior to this adjustment, the FFE rate had begun trading near the top end of the target range and the FOMC wanted to take this technical step to move the FFE rate back down in the range.
So how did it work?
The verdict is still out, but initially the FFE rate dropped to 1.90%. However, in subsequent trading days, the FFE rate moved up to 1.92%. While this was not exactly the result the FOMC was looking for, with markets typically trading thin leading up to quarter-end and a sample size too small, it may be too soon to judge the efficacy of this move. The FOMC will keep a close eye on this situation as the Federal Reserve (Fed) continues to shrink its balance sheet in the face of a forecasted increase in Treasury bill (T-bill) issuance in late July, which together has the potential of causing an upward drift in the FFE rate. The Fed’s balance sheet run-off currently stands at $30 billion per month but will increase to $40 billion in July and then $50 billion by October. This run-off, combined with added T-bill issuance, could keep the FFE rate at the top end of the range and perhaps necessitate another technical adjustment at some point.
Excess of IOER over FFE rate
Source: Bloomberg L.P.
In addition to the IOER technical adjustment at the June meeting, the FOMC updated the long-awaited Summary of Economic Projections (SEP). At the March FOMC meeting, it was a close call whether the members’ forecast called for the target rate to be raised a total of three or four times this year. In June, a change in a single committee member’s forecast was enough to adjust the median target rate increase higher to four rate hikes this year—in other words, two rates hikes remaining in 2018. The median federal funds target rate forecast was also adjusted higher by 25 bps in 2019 to 3.125% (mid-range).
The 2020 and longer-term view remains unchanged from March as the FOMC approaches its neutral rate in 2019–2020. On the economic front, the SEP adjusted gross domestic product 0.1% higher in 2018 to 2.8% and kept 2018 through the long run unchanged from the March projections. The SEP continued to incorporate an improving labor market, with the unemployment rate dipping to 3.5% in 2019 and 2020 before increasing to 4.5% in its long-run projections. Inflation expectations moved higher to 2.1%, which is in line with the committee’s comments surrounding the symmetric guidance in recent speeches.
Another tidbit from the June FOMC meeting was that starting in January 2019, the chair will hold press conferences after each FOMC meeting. This may not sound like much but market participants largely expect changes to the target rate only at meetings with press conferences—currently known as the four live meetings per year. This new communication strategy was largely viewed as allowing the FOMC some optionality to adjust monetary policy more frequently by effectively making each FOMC meeting a live meeting.
The FOMC appears to be comfortable enough with the current economic expansion, low unemployment rate, and symmetric inflation expectations to continue on its path of removing monetary policy accommodation at a gradual pace. Current federal funds futures implied probabilities confirm the market is in agreement with the FOMC assessment that rate hikes are mostly priced in for its September meeting and a roughly 50% chance at its December meeting.
U.S. government sector
Earlier this year, the Fed rolled out the Secured Overnight Funding Rate (SOFR) and other related repurchase agreement (repo) funding indices, with an eye toward SOFR eventually taking the key reference rate baton from a fading London Interbank Offered Rate (LIBOR). As repo market volumes dwarf those of the federal funds market, with a more diverse set of market participants, in SOFR the Fed has created an index to capture a much more representative picture of the overnight funding cost in the financial markets. Next, we’ll discuss certain components of the repo market, how the Fed’s new indices account for them, and the prospects for SOFR to eventually replace LIBOR.
First, the basics. Repos elegantly match parties with complementary needs. Borrowers need to fund the assets on their balance sheets, and lenders, including but not limited to money market funds, seek overnight or short-term investments in safe assets. A repo, essentially a loan and, in our markets, usually secured by Treasury, mortgage-backed, or agency securities, meets the needs of both. However, while the concept is straightforward, the repo market itself is complex, with a mix of counterparties interacting in different ways, presenting a challenge for the Fed in gathering transaction data.
The repo market consists of a number of segments. One is the market for tri-party repos, which itself has two sub-segments: dealer-to-customer repos and interdealer repos, which are executed through the GCF Repo® service offered by the Fixed Income Clearing Corporation (FICC). All tri-party repos are made against a pool of general collateral rather than specific securities.
In a dealer-to-customer tri-party repo, the customer (for example, a money market fund) negotiates with the dealer and therefore knows its counterparty but, as noted above, doesn’t know the specific securities being financed at the time of execution, only that they meet its general requirements. In its notice requesting information about the proposed rates, the Fed described a dealer-to-customer tri-party repo transaction as follows:
“In a tri-party repo, a clearing bank is used to facilitate the clearing and settlement of the transaction by managing the securities and ensuring that the securities adhere to the cash provider’s eligibility requirements … Tri-party repos settle on the books of the clearing bank, where cash and securities are transferred between the cash provider’s and securities provider’s respective accounts.”1
By contrast, with interdealer tri-party repos, the dealers on either side of the transaction only know FICC as their counterparty and thus know neither their ultimate counterparty nor the specific securities being financed. The Fed described these repos accordingly:
“GCF Repo … permits FICC’s netting members to trade cash and securities among themselves based on negotiated rates and terms. GCF Repo trades are completed on an anonymous basis through interdealer brokers and settle on the two clearing banks’ tri-party repo platforms. FICC acts as a central counterparty in GCF Repo, serving as the legal counterparty to each side of the repo transaction for settlement purposes.”2
Just to keep things nice and confusing, the dealer-to-customer repo market is often referred to as the GC market, while the interdealer repo market is referred to as GCF.
Aside from tri-party repo, a second major segment of the repo market is the bilateral repo market, described by the Fed as follows:
“Unlike the tri-party repo market, in the bilateral repo market, counterparties instruct their custodians to exchange cash and securities without the use of a third party to manage collateral and facilitate centralized settlement. In order to effect settlement, the parties identify specific securities for their custodians to transfer.”3
As with the tri-party market, the bilateral market is further segmented into two components: trades settled through FICC’s Delivery-versus-Payment service and those settled outside that platform, labeled “non-cleared bilateral repo” by the Fed. The latter represent a data collection problem for the Fed, which acquires its repo transaction data from FICC and the tri-party clearing bank. As these non-cleared trades are done outside those channels, the Fed is unable to include them in its repo indices. In contrast to the other segments of the market, in a non-cleared bilateral repo transaction, the parties know both their specific counterparty and the exact securities provided as collateral.
The Fed approached the task of quantifying repo market activity by producing several indices, each more inclusive than the last and thus building on one another. The most basic of its indices, the tiniest of the Russian nesting dolls, is the Tri-Party General Collateral Rate (TGCR), which measures the rate on overnight Treasury repo transactions in the dealer-to-customer tri-party market, specifically excluding FICC’s GCF repo transactions. Consistent with its methodology for calculating the federal funds rate, the Fed uses a volume-weighted median approach to calculate the TGCR, as well as the other new repo indices. The daily average of the total TGCR volume since publication began on April 2, 2018, has been $344 billion.
The Broad General Collateral Rate (BGCR) is the next incrementally more inclusive index, as it begins with the general collateral repo trades used in the TGCR and adds the GCF interdealer repo transactions done through FICC. BGCR volume since its inception has averaged $359 billion per day.
This leads us to SOFR, the whole enchilada, or at least most of it, when it comes to Treasury repo indices. In addition to everything in the BGCR, SOFR also includes bilateral Treasury repo transactions cleared through FICC’s Delivery-versus-Payment service but excludes non-cleared bilateral repo, due to the aforementioned data collection difficulties, and repo trades done with the Fed as a counterparty for the conceptual reason that they represent trades done at a policy rate rather than a market rate. SOFR’s average daily volume since its debut has been $777 billion. To give a sense of the scale and therefore the need for and importance of the new repo funding indices, the average daily volume over the same period for the federal funds market, the real headliner, and the more comprehensive Fed’s Overnight Bank Funding Rate were $80 billion and $159 billion, respectively.
The chart below shows how BGCR and SOFR have compared with the federal funds effective rate so far this year. For dates prior to the official launch of the repo indices on April 2, the Fed provided reconstructions, showing what likely would have been published had it been doing so at the time. In addition, the TGCR has been omitted from the chart, as it has varied from the BGCR on only one day in 2018 and by only 0.01% on that day.
Repo indices and Fed funds
Source: Bloomberg L.P.
Given the importance of the repo market to the overall funding picture in the financial markets, SOFR’s creation is overdue and would be worthwhile on its own, even in the absence of questions about LIBOR’s long-term viability. However, those questions exist with good reason, and it’s no coincidence that robust new SOFR is arriving just as battered LIBOR recedes. If not for the roughly $200 trillion of U.S.-dollar-based derivatives and loans estimated to be tied to LIBOR, it may well have faded out of existence already. LIBOR’s well-documented problems are multifaceted. The daily survey of large banks that was intended to report their transactional funding costs became, over time, largely an exercise in estimation as the volume of real trades underlying the reports diminished. With estimation apparently also came, at times, manipulation, for which a number of banks paid billions of dollars in fines. Bank managers reasonably concluded that continuing to participate in LIBOR submissions subjected the firms to ongoing legal exposure with no apparent benefit, and the easy solution to exit the process was forestalled only by the requirement that they continue by the U.K.’s Financial Conduct Authority (FCA). However, with the FCA pledging to stop compelling participation by the end of 2021, LIBOR’s future remains in doubt.
Given LIBOR’s uncertain future, the march to replace it has proceeded at a steady pace. In November 2016, the Fed announced its intention to develop and publish these overnight Treasury repo benchmark rates. In June 2017, the Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by official sector agencies to identify alternative U.S. dollar reference interest rates, identified the repo index that would eventually be named SOFR as the rate that would be the best choice for use in new U.S. dollar derivatives and other financial contracts:
“… the ARRC considered a variety of factors in selecting a broad repo rate, including the depth of the underlying market and its likely robustness over time; the rate’s usefulness to market participants; and whether the rate’s construction, governance, and accountability would be consistent with the IOSCO Principles for Financial Benchmarks. The ARRC believes that, measured against these criteria, a broad repo rate is the most appropriate for wide-spread and long-term adoption as a reference rate.”4
In April 2018, as noted above, the Fed began publishing SOFR, and in May 2018, SOFR futures began trading on futures exchanges. This last step is important because parties to contracts that reference SOFR will want the ability to hedge their commitments.
While the ARRC had plenty to consider and couldn’t please everyone, SOFR has a few attributes that will take some getting used to if it eventually becomes a primary replacement for LIBOR. First is that it is a risk-free rate, with no credit component. Since LIBOR measures unsecured bank funding costs, stresses in bank funding markets typically show in LIBOR straightaway, providing a reliable signal of developing credit problems. Second is that SOFR is choppy, with fairly significant swings on a day-to-day basis (as shown in the chart above), especially around month-end and even more severely on quarter-end, in contrast to LIBOR, which has tended to move in modest daily increments, at least when the world is not in a generational financial crisis.
Even with those issues, it’s easy to imagine SOFR replacing LIBOR as a reference rate in new derivative and loan contracts, with the institutional heft behind it. On the other hand, it’s the furthest thing from easy to imagine what happens to all the legacy contracts, those with years to go before they sleep, in the case of LIBOR’s sunset. There are bound to be winners and losers in each contract, and the losers are not likely to go quietly. Lawyers may be sharpening their pencils in anticipation.
After spending eight years with near-zero yields, money market funds are garnering attention as a real asset class again: Cash is NOT trash! The bear flattening of the U.S. Treasury curve and sputtering performance of equities have brought favorable attention back to the short end of the yield curve. To place this in context, large-cap equities, as represented by the S&P 500 Index,5 have returned only 2.65% in the first half of the year; during the same time, high-grade corporate bonds, as represented by the Bloomberg Barclays U.S. Corporate Bond Index,6 have turned negative, returning -3.27%. In contrast, prime institutional funds look relatively attractive, having returned 1.54% on average through May 28, according to iMoneyNet. As a result, the rise in short rates has brought not only attention but perhaps also nontraditional money market investors (those that typically invest in longer-term debt or equities) into the short end of the market. According to Crane Data,7 institutional prime money market assets rose almost $600 million in June, and total commercial paper outstandings not seasonally adjusted were up $5.5 billion through June 28. Those two figures might lead one to conclude that rates on investments needed to increase in order to attract buyers. But even with a Fed rate hike this month, three-month LIBOR has barely budged, increasing a mere 1.5 bps since the end of May. One could speculate that June’s hike was fully priced in before the meeting. But since more hikes are expected this year, three-month LIBOR would usually start to rise in anticipation of the next move, so it’s possible that the dampening effect of an increase in demand from other buyers is responsible for this departure in the typical behavior we expect to see during a tightening cycle.
Money market yield curves
Sources: Bloomberg L.P. and Wells Capital Management
As illustrated above, the LIBOR curve flattened after the June FOMC meeting as very short maturities adjusted higher with the rate hike and the longer end of the curve moved only marginally higher. The movement of the front end of the curve makes sense as it closely follows FOMC actions, whereas the longer part of the curve takes its cue from market expectations for future rate hikes. As actual rates move closer to the current SEP neutral federal target rate of 2.90%, it will take additional communication and further economic strength to steepen the LIBOR curve.
LIBOR yield curves
Sources: Bloomberg L.P. and Wells Capital Management
Against a backdrop of favorable economic conditions and an FOMC that is anticipating removing accommodation for the foreseeable future, we continue to favor maintaining our funds’ weighted average maturities shorter than the industry average and maintaining a high degree of interest rate sensitivity. These shorter profiles also may afford us the flexibility to add longer-dated product as opportunities arise. While rates in general continue to drift higher, we believe our investment strategy of emphasizing highly liquid portfolios, relatively short weighted average maturities, and a position in securities that reset frequently should allow us to capture future FOMC rate moves with minimal net asset value pricing pressures.
Wells Fargo FNAV money market fund NAVs
Source: Wells Fargo Funds
Wells Fargo FNAV money market fund weekly liquid assets
Source: Wells Fargo Funds
The municipal money market space continued to exhibit roller-coaster-like rate action this month, as usually dependable seasonal cash flows ran counter to expectations for the second month in a row. Whereas municipal money market fund assets grew by a surprising $6.2 billion during the month of May (an astonishingly large inflow for a typically quiet month), June saw equally unexpected outflows of roughly $2.8 billion. This unforeseen reversal in trend caused demand for overnight and weekly variable-rate demand notes and tender option bonds to evaporate, leading dealers to rapidly ratchet rates higher in order to entice nontraditional buyers in the short end of the curve. The FOMC rate hike on June 13 provided additional impetus for the tax-exempt market to play catch-up after May’s unexpected drop in rates left tax-exempt to taxable ratios at their lowest level of 2018. The Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index8 would ultimately rise from 1.05% (59% of one-week LIBOR) on June 6 to 1.51% (76% of one-week LIBOR) on June 27.
Further out on the curve, yields on high-grade commercial paper reversed May’s drop by jumping roughly 15 to 20 bps in the one-month to three-month space. “Note season” got into full swing during the month and the new issue calendar was loaded with perennial issuers such as the city of Los Angeles ($1.5 billion), Los Angeles County ($700 million), and the state of Idaho ($540 million) selling benchmark one-year paper at approximately the 1.55% level. The municipal money market yield curve flattened further as yields on one-year fixed-rate paper actually fell by roughly 12 bps for the month. The tax-exempt yield curve remains compressed throughout the money market and short-duration space due to continuing supply constraints in the broader municipal market.
During the month, we continued to emphasize principal preservation and liquidity by focusing our purchases in variable-rate demand notes and tender option bonds with daily and weekly puts. Despite the recent volatility in rates in the short end, we continue to feel that this sector of the curve remains attractive on both a nominal and tax-adjusted basis, particularly in light of the relative flatness of the municipal money market yield curve. Additionally, we continue to feel that a conservative posture with respect to weighted average maturity is warranted given the expectations of additional FOMC rate hikes in the second half of the year.
On the horizon
If past experience is any predictor of the future, over the very near term we are anticipating long, light-filled days at temperatures conducive to outdoor activities. If this holds true, our expectations are that many industry participants will take time away from work in order to pursue leisure activities with friends and family. While many of these activities may involve sports and recreation of some sort—possibly in, on, or near bodies of water—they may also revolve around dining al fresco and displays of pyrotechnics. During this period, some locales may produce a state fair, at which residents of said state or region enthusiastically assemble to compete in the domestic arts, display their produce and livestock, partake in carnival rides, and eat food that comes on a stick. The Minnesota State Fair is one such festival—in fact, it is the largest by average daily attendance and second only to Texas in total attendance—and concludes its 12-day run on Labor Day. At that point, we, too, will return from our hiatus and resume our market commentary. Until then, we wish everyone a safe and event-filled summer.
Rates for sample investment instruments—Current month-end % (June 2018)
|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||2.11||2.05||–||–||–||–||–||Cash Investment MMF*–Select||2.10|
|Fed reverse repo rate||1.75||–||–||–||–||–||–||Heritage MMF*-Select||2.09|
|U.S. Treasury bills||–||–||1.73||1.85||1.88||2.06||2.24||Municipal Cash Mgmt MMF*–Inst'l||1.44|
|Agency discount notes||1.61||1.64||1.76||1.86||1.90||1.97||2.12|
|Asset-backed commercial paper||1.94||1.97||2.08||2.20||2.30||2.53||–||Treasury Plus MMF**-Inst'l||1.74|
|Dealer commercial paper||1.90||1.91||1.88||1.96||2.07||2.28||–||100% Treasury MMF**-Inst'l||1.68|
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 1.98%, 2.00%, 1.33%, 1.74%, 1.71%, and 1.60%, 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 (the total annual fund operating expenses after fee waivers) as stated in the prospectus.
1. Request for Information Relating to Production of Rates, A Notice by the Federal Reserve System on 8/30/2017, Federal Register, Pages 41259-41262, Document Number 2017-18402
2. Request for Information Relating to Production of Rates, A Notice by the Federal Reserve System on 8/30/2017, Federal Register, Pages 41259-41262, Document Number 2017-18402
3. Request for Information Relating to Production of Rates, A Notice by the Federal Reserve System on 8/30/2017, Federal Register, Pages 41259-41262, Document Number 2017-18402
4. ARRC Press Release, 6/22/2017, https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/ARRC-press-release-Jun-22-2017.pdf
5. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index.
6. The Bloomberg Barclays U.S. Corporate Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. You cannot invest directly in an index.
7. Crane Data is a money market and mutual fund information company founded by Peter G. Crane and Shaun Cutts. Crane Data collects money market mutual fund, bank savings, and cash investment performance, statistics, and information and distributes rankings, news, and indices. Crane Data publishes Money Fund Intelligence, Money Fund Intelligence XLS, Money Fund Wisdom, the Crane Money Fund Indexes, and a series of products tracking money markets, mutual funds, and cash investments.
8. 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. 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 June 30, 2018, and are those of the fund managers and the Money Market team at Wells Capital Management, 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.