With central banks simultaneously trying to support economic reopenings post-Covid and manage a surge in inflation, the knock-on effect has been felt in both the short-term investment space and corporate cash management. Daniel Farrell of Northern Trust Asset Management, and James Douglas of Rabobank, spoke during a recent TMI webinar about how market trends may evolve in the year ahead and what this could signal for treasurers.
As the news around the Covid-19 pandemic evolved in 2021, so too did the financial markets. At the beginning of the year, good news broke about the various vaccines being created by multiple pharmaceuticals. However, there was still uncertainty around the roll-out and how quickly that could happen. At that point, central banks still had very loose policies, with market expectations that the Bank of England might take the base rate negative. Contrast that with the end of 2021 when a potential base rate of more than 1% was mooted for the end of 2022.
Daniel Farrell
Director, International Short Duration Fixed Income, Northern Trust Asset Management
“Central bank reaction and the need for any monetary policy certainly evolved over 2021,” reflects Daniel Farrell, Director, International Short Duration Fixed Income, Northern Trust Asset Management (NTAM). “Interest rates have been anchored at these low levels, while at the same time we have seen the impact of quantitative easing from central banks including the Federal Reserve, the European Central Bank [ECB] and the Bank of England, which has been creating a lot of excess liquidity in the market, particularly in the front end. At the same time, there were other liquidity operations, such as the ECB’s targeted longer-term refinancing operations, which were essential in the pandemic but have caused downward pressure to front-end yields.”
Another central theme that arose in the final quarter of 2021 was inflation, specifically the inflationary outlook. That created the question as to whether central banks need to take more aggressive action with potential interest rate rises, and how many rate hikes could be needed if more sustained inflation were ahead.
For corporate treasurers, these market trends have had a significant impact on their cash investments in a couple of key ways, starting with the compression in yields. Short-end investors, including MMFs, have been on the wrong side of a supply and demand dynamic. There is huge demand due to excess liquidity, but supply has been diminished, compressing those front-end yields and hurting treasurers who must hold cash. The decrease in supply has also had another impact.
“There has been less supply from the banks to absorb liquidity, especially over key periods such as year-end,” says Farrell. “There are not enough high-quality, short-duration investment options for the amount of liquidity that we see in the market now. This means that treasurers and other investors have not only had to navigate the low interest rate environment but they’ve also had to navigate how they will invest their cash.”
All eyes on central banks
The themes from the second half of 2021, specifically from the final quarter, will continue to play a part in 2022. For example, the reaction function of the central banks is under particular scrutiny.
“Now that economies are starting to reopen and become more normalised, we are starting to see what this means for the labour markets and inflation,” continues Farrell. “The UK, European countries, and the US have either pulled back on their fiscal labour support programmes or will do so in the coming months. Once that has happened, and if the central banks can see that labour markets remain functioning well – and some of the labour data we’ve seen recently that shows that the market is performing well – that will tick one of the boxes for the central banks.”
The inflationary outlook is causing central banks even more headaches. Despite the Federal Reserve Chairman, Jerome Powell, stating he wanted to retire the word ‘transitory’ in relation to the current inflation rise, there are many transitory inflation base effects working their way through the data.
“While it is taking longer than expected for these base effects to work through, we do expect that they will in 2022,” notes Farrell. “The biggest risk to our outlook is if this takes longer and these bleed into second-round effects, and whether that could cause sustained inflation above the 2% target central banks have over an extended period. The central banks have recognised this risk and recently become more hawkish.”
Rate hikes are posing significant questions for treasurers and other short-end investors. At the end of 2021, the market was pricing in rate hikes in an aggressive manner for the 12 months ahead. However, Farrell comments that this is not the view of NTAM: “We still don’t believe that is going to occur. There may be the need for some moderate tightening if inflation remains elevated and employment data is still positive in the next few quarters. However, we still believe the number of hikes will be below what the market currently has priced in.”
A final wild card consideration is around other Covid variants that might spring up, such as the Omicron variant that emerged at the end of 2021. This will continue to be a factor that treasurers will have to be aware of due to the uncertainty it creates. Variants could pose downside risk to employment, economic activity, and create further inflationary pressures, which may result in the central banks having to rethink their policy directions.
For corporate treasurers, as well as monitoring the actions of central banks, it will also be key to keep abreast of any changes that MMFs may make as a result of the market conditions.
James Douglas
Fixed Income Sales-Trader, Director, Rabobank
James Douglas CFA, Fixed Income Sales-Trader, Director, Rabobank, suggests that treasurers could be well served by using the next six months to a year to see how MMF positioning correlates to the goals that they want to achieve.
“If the primary objectives are capital preservation and liquidity availability, I’d be looking at the fund next year in terms of the liquidity buffers, risk metrics – the weighted average maturity of the fund and the weighted average life of the fund – and just judging whether they stay on historic trend regardless of whether the curve steepened,” Douglas says. “Ideally, they should be treated more like a passive than active vehicle. On the other hand, if I were looking for yield through the MMF, I’d be using the opportunity to make sure that the funds are getting the big questions more right than wrong and have positioned themselves at the right point of the curve.”
Regulatory proposals and ESG challenges
As well as the various market changes, 2021 also saw multiple consultation papers issued around the potential for future money fund regulatory changes. With consultations ongoing, it is unlikely that any such changes will be made this year, but more details regarding the content of such proposals will become more evident.
Farrell explains: “The consultation papers address both the liability and the asset side of MMFs. Some of the most important issues for corporate investors to be aware of include the potential for the decoupling of fees and gates from liquidity thresholds, the use of an anti-dilution levy in swing pricing, and changes to daily and weekly liquidity thresholds. Another big proposal is to remove public debt constant NAV [net asset value] funds and low volatility NAV funds and switch to variable NAV funds. That would be a major change for corporate treasurers, who we know have always liked the fact that money funds have a stable NAV.”
Treasury has been one of the organisational functions at the vanguard of supporting corporate goals in the ESG space through financial tools such as green and social bonds, green deposit accounts, and sustainable supply chain finance. However, ESG-related options are relatively hard to come by in the short-term investment space, despite interest from corporates.
“We are asked a lot of questions around ESG in our conversations with both existing investors and prospects, and there is absolutely an increasing demand for ESG-integrated solutions,” says Farrell. “There are still challenges around integrating an effective ESG solution in MMFs. This is primarily down to the fact that we are highly exposed to financials and to banks, so while it can be meaningful from a governance perspective, it is less so on the environmental and the social side just because of the nature of the underlying sectors that we buy into. We’ve been talking to investors, we understand the need and are working to create solutions for them. Something treasurers can do is look at a cash segmentation strategy and, if they have the ability, to consider moving out of an MMF and into a short-duration ultra-short bond fund. These have much wider diversification from a sector perspective, so actually integrating a meaningful ESG solution is much more achievable.”
A number of rating agencies with strict ESG assessment criteria, including Sustainalytics, Institutional Shareholder Services (ISS) and MSCI, have emerged in recent years. Issuers that score favourably with agencies such as these are likely to have positive ESG credentials. Still, as Rabobank’s Douglas points out, it can be challenging for MMFs to fit these criteria for other reasons.
“We have two short-end instruments that fall under our sustainable funding framework – green deposits and sustainable commercial paper,” Douglas explains. “Both are structured so that the cash received will be given towards projects that come under the International Capital Market Association Green Bond Principles. However, from a green deposit perspective, that’s not something that MMFs get involved in because the minimum tenor is 30 days, and that’s too far from a regulatory perspective for MMFs. It’s more in line with investors who have segregated cash mandates or individual deposit placers.”
Maximising short-term investments
Short-term corporate cash management will remain under duress this year due to various pressures outlined in the liquidity market, interest rates and inflation, and the potential for regulatory change. For some treasurers, this could be the right time to reassess their approach to short-term investments to make the most of the cash they can allocate to these strategies.
“Treasurers should look at their cash in a very strategic way and have a focused approach in liquidity management,” advises Farrell. “Moving away from the one-size-fits-all approach of bank deposits, call accounts and MMFs, and instead looking at what other options they have. A cash segmentation strategy is key to this – understanding the uses and needs for their cash and then allocating this to three defined buckets. These are typically operational cash, where it should be in short-term, instant-access vehicles; reserve cash, which is more for those quarterly payments; and strategic cash, which is if they have the ability to look at longer-term cash uses.”
For treasurers who split out cash uses in that way, the door is then open to solutions where it is possible to increase diversification, integrate ESG, obtain a better risk-reward balance and be able to take advantage of some of the high yields seen outside of the money market space.
“You can achieve higher yields by utilising a combination of MMFs and ultra-short bond strategies, which complement each other,” adds Farrell.
This positivity is shared by Douglas, who notes that yield may be making a comeback in 2022.
“Money market yields have been pretty low for the past 18 months, but we are seeing hikes priced in, and therefore gross yields should be on the way up,” Douglas predicts. “That’s certainly a positive. It’s also important for treasurers to keep on trying to figure out the transitory inflation puzzle. Remember, it’s what you think central banks will do in terms of tightening policy that’s important, rather than what you think they should do.”
Farrell offers two key takeaways for treasurers that highlight a couple of the biggest trends in the short-term investment space for 2022: MMF regulation and potential interest rate hikes.
“Pay close attention to regulatory developments that may happen in 2022,” concludes Farrell. “Also, while market expectations are that there are going to be rate hikes, the number of rate hikes may disappoint, so be prepared [for the fact] that we may still be in this low-for-longer environment even if we do see moderate rate hikes from the central banks.”
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