Liquidity lowdown: New year brings rate cuts into greater focus

Since the global financial crisis, returns on liquidity funds have been historically low. That has changed over the past two years as central bank interest rates have risen. With these peaking, this new regular blog will look in more detail at what is going on in cash and liquidity markets and the implications for investors.

It almost feels like a waiting game now. Cash funds have been thriving in an environment where yields have been edging higher since the Bank of England started their rate hiking cycle back in December 2021.

But with inflation on the way down and the peak in rates more than likely reached, money markets are now waiting for the long-anticipated decline in yields to begin. The trajectory for interest rates is never straightforward, but with a current expected UK Base Rate of around 4.00% by the end of the year, it is hard not to think that the market has got slightly ahead of itself. Geopolitical tensions, high wage growth, a tight labour market and an unemployment rate which is still relatively low, all suggest that rates may not come down as rapidly as market pricing suggests.

Where does that leave money market funds? The usual December lull feels like a distant memory, and with people squaring up their positions earlier and earlier in the year, fewer transactions going through at year end meant that there was still a demand for cash, and year end almost felt ‘normal’. We also believe Liability Driven Investment (LDI) funds have much to do with the sense of normality this year end brought about. The crisis in the last quarter of 2022 saw LDI funds greatly de-leverage risk. The large cash collateral movements which were becoming a frequent occurrence have now started to become a thing of the past.

Logical thinking would suggest if there is less cash in the system, banks would be unable to squeeze levels to the extent that we’ve seen all too often in the past. Whether this trend continues we will need to wait and see, but it feels like a very different story to last year where an abundance of cash in the system meant there was little appetite from banks to offer attractive levels on overnight repo. But in any case, the typical eeriness in markets with a general lack of supply have now passed us, and January has bought back liquidity and reasonably well functioning markets. Treasury bills continue to be well bid, with spreads reasonably tight between the highest and lowest yields accepted at the weekly Friday auction. Greater supply would largely be welcomed as money market funds look for liquidity in shorter dated government bonds.

Rate cut expectations have certainly reflected into yields on certificates of deposit (CDs), and the full force of those expectations can be felt across money markets. Yields on one-year CDs have long drifted off their highs, but are still currently yielding over 5%. The start of December saw yields around 30 basis points higher, but with so many rate cuts currently priced in, is short duration cash still an attractive place to invest cash or is time to look at longer duration strategies?

Our view is that short duration cash strategies still offer attractive returns on a risk-adjusted basis, and with the potential for more market volatility in 2024, cash is certainly one asset class that could help protect against this.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.