Portfolio Manager Commentary
Overview, strategy, and outlook: As of August 31, 2018
The month of August is notoriously slow in this business. A number of firms in our industry still require that employees take two consecutive weeks off at some point during the year, and while many of those vacations occur throughout the summer, they seem to be especially back-loaded into the month of August. Not surprisingly, market practices are also accommodative of this phenomenon. As one sell-side market analyst recently noted, issuers are urged—presumably by their dealers—to avoid maturities in late August, and the numbers from the Federal Reserve’s (Fed’s) commercial paper statistics seem to back this up: Average volume issuance for the month of August was down over $6 billion versus the average of July! At the same time, however, prime fund assets grew by over $26 billion in August, evenly divided between retail and institutional funds, reaching a new post-reform high of $688 billion (as reported by Crane Data).
The Federal Open Market Committee (FOMC) met on August 1 and, as expected, left its target rate unchanged at a range of 1.75% to 2.00%. There were very few changes in the corresponding statement and the tone of the policy statement continues to point to gradual rate hikes going forward. In the wake of this nonevent, focus turned to the annual Economic Symposium in Jackson Hole, Wyoming. With Jerome Powell scheduled to deliver a speech titled Monetary Policy in a Changing Economy, expectations were that some clues about the future path of rates might emerge from the conference. And, not surprisingly, the Fed chair’s speech stayed close to recent Fed communications, reinforcing market expectations for a September rate hike and providing support for additional tightening if the economy continues on its current course. The FOMC’s consensus view is that the gradual process of normalization remains an appropriate middle ground based on strong growth and low unemployment. In addition, inflation readings remain stubbornly muted, with the Fed chair acknowledging there “does not seem to be an elevated risk of overheating, with no clear sign of an acceleration above 2%.” In the money markets, the current federal funds implied futures expectations agree with the FOMC assessment, assigning a roughly 95% chance the FOMC raises its target range to 2.00% to 2.25% at its September 26 meeting and a just over 60% chance of another 0.25% hike at the December 19 meeting.
The path of money market rates has generally followed the anticipated gradual pace of removing policy accommodation set by the Fed, and those rates continue to have a positively sloping yield curve. However, the reduction in money market supply in August has kept a fairly strong bid to investments with short maturity dates, causing rates to be a little slow to react to upcoming rate increases. This strong bid can be observed in the dramatic tightening of the London Interbank Offered Rate-Overnight Investment Swap (LIBOR-OIS) spread since its widest spread in April. As you may recall, the LIBOR-OIS spread represents the difference between an interest rate with some credit risk built in (LIBOR) and one that is relatively risk-free (OIS). The spread elevated to +59 basis points (bps; 100 bps equal 1.00%) through the first week of April before retracting off the highs at the end of tax season. Unlike previous episodes, this spread widening was due to supply and demand imbalances, not to credit stress in the markets. The current spread of +21 bps is a new low for the year.
Money market yield curves, as of 8/31/2018
Source: Bloomberg L.P. and Wells Capital Management
Source: Bloomberg L.P. and Wells Capital Management Inc.
Against this backdrop of favorable economic conditions and a Fed that is anticipating removing accommodation for the foreseeable future, we continue to favor maintaining our funds’ weighted average maturities shorter than the industry average while still offering a favorable risk-adjusted yield. As we get closer to the FOMC terminal rate of 3.25% to 3.50% targeted by the Fed’s Summary of Economic Projections, money market participants may look to extend weighted average maturities (WAM)1 to lock in higher yields, but we are more than a few months and a couple of revised projections away from that scenario. In the meantime, breakeven yield calculations still favor buying short-dated fixed maturities or securities that reset frequently over longer-dated maturities and resets. While rates in general continue to drift higher, we believe our investment strategy of emphasizing highly liquid portfolios, relatively short WAMs, and a position in securities that reset frequently should allow us to capture future FOMC rate moves with minimal net asset value (NAV) pricing pressures and afford us the flexibility to add longer-dated product as opportunities arise.
Wells Fargo FNAV money market fund NAVs
Source: Wells Fargo Funds
Wells Fargo FNAV money market fund weekly liquid assets
Source: Wells Fargo Funds
U.S. government sector
On the government side, market participants spent the summer looking ahead with either nervous or greedy anticipation to the upcoming surge in Treasury bill (T-bill) supply. The last supply bulge, in the first quarter, proved to be a bit too much for the market to handle gracefully, with the Treasury issuing $332 billion of new T-bills over eight weeks. A similar experience, however, was not to occur this time, as $183 billion in additional supply was issued over the past seven weeks. Although nothing to sneeze at, the more modest size and pace this time around were apparently in the market’s comfort zone, as it was able to absorb the supply with little disruption or volatility. With no live Fed meetings between June and September, and with the market’s nonchalance in the face of supply, summer’s tranquility was uninterrupted, if not reinforced. The weekly net change in T-bill issuance over the past year can be viewed in the chart below:
Weekly net new T-bill issuance
Source: U.S. Treasury
One measure of the market’s response to changes in supply can be found in the yield on 1-month T-bills. As shown in the chart below, 1-month T-bill yields typically chopped around in a range just below the Fed’s reverse repo program (RRP) rate, which is set at the bottom of its overnight target range. As an expected rate hike approached, the yields would rise in anticipation before settling back into the range after the hike. The saw-tooth picture drawn by the yields around Fed hikes has continued, but the spread was markedly higher by the spring supply boost and has yet to return to its former range. That said, the market’s current composure is evident, as yields reached 0.44% over the RRP before the March rate hike (when supply was burning hottest), then 0.30% before the June hike (when supply had moderated), and have recently reached 0.20% with one month to go before a likely September hike.
1-month T-bill yield/RRP spread
Source: Bloomberg L.P. and Wells Capital Management
Another measure of the market’s ability to digest supply is the behavior of the repo market. The chart below comparing market repo rates with the Fed’s RRP rate tells a similar story. The spring supply bump pushed yields well out of their former range, followed by a period of moderation in a new higher range as supply waned, giving way recently to modestly higher rates that are still well below the spring’s peaks.
Excess of tri-party repo over RRP
Source: Federal Reserve Bank, Bloomberg L.P., and the Bank of New York
Due to the seasonality of the Treasury’s cash flows, T-bill supply is set to moderate again in September, but only briefly. The U.S. government is back to running ever-larger deficits (cutting revenues while expanding outflows will do that) that will need to be financed, and T-bills will likely be part of its additional funding mix. As the Treasury’s financing needs grow again in the fourth quarter, it will meet some of that with a new product, the 2-month T-bill. To general financial market participants, this will be so off the radar as to not even merit a yawn. But for money market investors, any new Treasury product is at least a little exciting, even if it’s not a real new product, just a different way of selling an old one. The Treasury expects the first 2-month T-bill auction to take place the week of October 15.
The 2-month T-bill brings with it a change to the auction and settlement calendar for portions of the T-bill spectrum. Forgive the dive into T-bill auction mechanics, but currently, 3-month and 6-month T-bill auctions take place on Mondays and settle and mature on Thursdays. One-month T-bill auctions occur on Tuesdays and also settle and mature on Thursdays. In these heady supply days, that’s an awful lot of paper maturing on one day of each week (Thursday), and the new 2-month T-bill introduction gives the Treasury the perfect opportunity to shift some of that to another day, which it feels will enhance its cash management and reduce operational risks. To that end, after a short transition period, both the 1-month and 2-month T-bill auctions will take place on Thursday, settle the following Tuesday, and eventually mature on Tuesday. The additional settlement and maturity day will likely be welcomed by investors.
Yields in the municipal money market space continued their seesaw pattern during August as benchmark rates rose across the entire curve. Municipal money market rates have experienced an elevated level of volatility throughout the year as traditional seasonal technicals have continued to be exacerbated by the implementation of the Tax Cuts and Jobs Act of 2017, which had the effect of sharply reducing municipal bond supply in the current year. Accordingly, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index2 has experienced its fair share of volatility as demand for overnight and weekly variable-rate demand notes (VRDNs) and tender option bonds (TOBs) has sharply fluctuated during alternating bouts of heavy reinvestment demand. During the month, SIFMA reversed July’s severe drop by rising to a multi-week high of 1.58% on August 22, up from 0.94% on July 25, as new issue supply in the latter half of the month relieved pressure on short-term rates.
Further out on the curve, yields on high-grade commercial paper and notes also rose, spurred by increasing levels on floating-rate securities as well as the surge in supply of cash flow notes. Large issues from Texas ($7.2 billion) and Massachusetts ($1.5 billion) highlighted the new issue calendar for the month. The Texas issue was $1.8 billion larger than last year and required a significant concession in yields to attract non 2a-7 buyers. Yields on Texas ranged from 1.79% to 1.83% during primary bidding and dealers were left holding large positions going into month-end. Accordingly, one-year high-grade benchmarks were forced to adjust higher, rising from 1.58% to 1.82% by month-end, largely due to the overhang of supply in this sector of the curve.
During the month, we continued to invest primarily in VRDNs and TOBs with daily and weekly puts for principal preservation and liquidity. We continue to feel that this sector of the curve remains particularly attractive on both a nominal and tax-adjusted basis. Additionally, we continue to maintain a conservative posture with respect to weighted average maturity given the relative flatness of the municipal money market yield curve and expectations for additional FOMC rate hikes in the near future.
On the horizon
In the midst of the summer slowness, something occurred that we have not seen in many years: A new type of security came to the market. The structure itself was not new, it was a floating-rate note, but the index off which it reset was new: SOFR. In our June commentary, we discussed the inception and structure of the Secured Overnight Funding Rate (SOFR) and its design to ultimately replace LIBOR, which is scheduled to be phased out by the end of 2021. The inaugural issue of a floating-rate note with SOFR as the index came as somewhat of a surprise from Fannie Mae in the form of a $6 billion multi-tranche deal. While the note was met with a warm reception, distribution was not as wide as it ultimately will be as Standard & Poor’s, which assigns a triple-A rating to 51% of all money market fund assets, had not yet approved it as an eligible index for funds it rates. However, shortly after the Fannie Mae issue came to market, Standard & Poor’s did analyze SOFR and included it as an eligible index in its methodology. After this transaction, a few additional issuers tested the market—including a corporate issuer—and we expect more issuance of this type of security will become a trend as we progress toward year-end.
Rates for sample investment instruments—Current month-end % (August 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||1.95||1.95||–||–||–||–||–||Cash Investment MMF*–Select||2.09|
|Fed reverse repo rate||1.75||–||–||–||–||–||–||Heritage MMF*-Select||2.08|
|U.S. Treasury bills||–||–||1.90||1.98||2.06||2.21||2.37||Municipal Cash Mgmt MMF*–Inst'l||1.47|
|Agency discount notes||1.89||1.85||1.94||2.02||2.08||2.21||2.42|
|Asset-backed commercial paper||1.94||1.95||2.06||2.17||2.28||2.51||–||Treasury Plus MMF**-Inst'l||1.82|
|Dealer commercial paper||1.98||1.98||1.98||2.10||2.18||2.41||–||100% Treasury MMF**-Inst'l||1.81|
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%, 1.98%, 1.35%, 1.80%, 1.79%, and 1.73%, 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. 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.
2. 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 August 31, 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 Funds 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.