The Federal Reserve's response to expectations of interest rate cuts over the past two weeks has prompted investors to stop monitoring inflation data and pile more money into money market funds.
Investors stashed a record $6.48 trillion in U.S. money market funds as of the end of January, with the balance growing as December euphoria over the Fed's policy pivot faded, according to Crane Data.
Federal Reserve Chair Jerome Powell first poured cold water on strong expectations for rate cuts at a policy meeting in late January by indicating that a rate cut in March was not likely. He followed that up days later with an interview on CBS News' “60 Minutes,” where he told 6.6 million viewers that the central bank would be cautious about interest rate cuts because inflation had not yet been convincingly tamed.
“He put a huge damper on it,” said Deborah Cunningham, chief investment officer for global liquidity markets at Federated Hermes, a group with $560 billion in money market assets as of December 31. “The market has outdone itself.” In November and December.”
Cautious bonds
Previous optimism about lower interest rates, perhaps in March, helped US bond funds turn positive in 2023.
However, many benchmark bond indexes were back in the red in February, with the 10-year Treasury yield BX:TMUBMUSD10Y rising to 4.186% on Friday, the highest level since mid-December.
“The stock market won't notice, but the bond market is definitely listening to Powell,” George Catrambone, head of fixed income at DWS Group, said in a phone interview.
“Powell removed the pot in January, but it was necessary,” he said. “They need to watch out for the return of inflation.”
Against this background, Catrambone described next Tuesday's release of the January CPI as the “main event” of the week, especially after the strong January jobs report and data showing the US economy grew by 3.3% in the fourth quarter.
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The seasonally adjusted CPI for the fourth quarter was released Friday at an annual rate of 3.3%, underscoring the progress the Fed has made in reducing price pressures from a peak of more than 9% this cycle. However, the cost of living is still higher than the central bank's target of 2%.
“I think the Fed is happy with the progress that inflation has made so far, but we need to see more,” Catrambone said. Against this backdrop, he remains a proponent of investing in the front end of the Treasury yield curve, particularly with 6-month Treasury interest rates BX:TMUBMUSD06M hovering above 5% for about a year.
“Although the level of reduction is high, the level of leverage is even higher,” Catrambone said.
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Completion of the Standard & Poor's 500 Index
Cautious tone in the bond market in recent weeks has been largely missing from US stocks, as both the Dow Jones Industrial Average (DJIA) and the S&P 500 are on a record run to start 2024, and the Nasdaq Composite is not far behind.
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Holding cash can be tempting, especially last year when recession fears were at the forefront for a prolonged period, said Adam Hitz, global head of multi-asset at Janus Henderson Investors.
“Investors are now anticipating a Goldilocks scenario,” a situation in which the economy continues to grow but inflation continues to fall, Hitz said. Along the way, they will likely need to endure “hot and cold economic news.”
“Investors have focused too much on the recession crystal ball and turned to cash, lured by high interest rates,” Hitz said. But by avoiding stocks, investors had missed out on the S&P 500's roughly 23% advance in the past 12 months, according to FactSet data.
“Cash is king for short-term liquidity needs, but cash overweight can be toxic to long-term financial planning,” Hitz said.
To this end, he prefers a more traditional 60:40 allocation to stocks and bonds, especially in light of the higher yields available on medium-term fixed income to compensate for any turmoil that might erupt in stocks that appear “priced to perfection.”
The S&P 500 SPX on Friday closed above the 5,000 mark for the first time ever, while rising 1.4% over the week to close at a record high of 50,526.61, according to Dow Jones Market Data.
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The Dow Jones advanced less than 0.1% for the week, ending at 38,671.69, while the Nasdaq rose 2.3% for the week, closing at 15,990.66, just 0.4% behind the previous record set in November 2021, according to Dow Jones Market Data.
Meanwhile, cash held in money market funds has gained about 5% for several months, supported by the yield on 1-month Treasuries BX:TMUBMUSD01M and 3-month BX:TMUBMUSD03M at about 5.38% as of Friday, according to FactSet.
With a new “real estate check” in markets over expectations of interest rate cuts this year, Fed Hermes's Cunningham said reaching a $7 trillion balance for money market funds is not hard to envision.
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