January 25, 2022
Fed Speeds Up Tapering, While BoE Increases Rates
January 25, 2022
Federal Reserve Board1
The Federal Open Market Committee (FOMC) voted unanimously to keep the federal funds rate unchanged at a range of 0.00% to 0.25% at the conclusion of its December meeting. Of particular note, and in line with recent market expectations, the Federal Reserve (Fed) announced that it would accelerate the winding down of its asset purchase program, increasing the reduction from $15 billion to $30 billion a month. This puts the Fed on pace to conclude the program around March 2022.
The December meeting included an update of the Fed’s summary of economic projections. The 2022 “dot plot” now shows all 18 voting members believe a rate hike is appropriate in 2022, an increase from nine members in the September projection. The median expectation for the fed funds rate is 1.6% and 2.1% at the end of 2023 and 2024, respectively. The FOMC downgraded its 2021 real gross domestic product (GDP) forecast to 5.5% from 5.9% estimated in September. The downgrade in GDP can be attributed to rising COVID-19 case counts and supply chain bottlenecks. Additionally, the Committee increased its inflation projections to 5.3% for 2021, up from its September forecast of 4.2%, for personal consumption expenditures (PCE). 2022 PCE projections increased 40 basis points to 2.6%. In addition, the Fed estimates core PCE rising to 4.4% for 2021, higher than the 3.7% forecast in September, but ultimately leveling out marginally above 2% in the years following.
European Central Bank1
At the European Central Bank’s (ECB) policy meeting on December 16, President Lagarde and the policy committee left the ECB deposit rate unchanged at -0.50%, as expected. The committee left the total size of the pandemic emergency purchase program (PEPP) and asset purchase program (APP) unchanged. However, the ECB noted it would reduce the pace of purchases under the PEPP in the first quarter. The release noted, “progress on economic recovery and towards its medium-term inflation target permits a step-by-step reduction in the pace of its asset purchases over the coming quarters.” Purchases under the PEPP will end in March 2022. Similarly, the Governing Council will reduce the size of purchases under the APP by €10 billion a quarter until October 2022 where purchases will level off at €20 billion a quarter for “as long as necessary to reinforce the accommodative impact of its policy rates.”
Bank of England1
The Bank of England (BoE) Monetary Policy Committee (MPC) voted 8-1 to increase the Bank Rate 0.15% to 0.25% in response to elevated inflation. The MPC unanimously voted to leave the size of its U.K. government bond purchase program unchanged at the conclusion of its December 16 meeting. The committee was undeterred by the omicron variant, although noted it “poses downside risks in early 2022.” Policy will continue to focus on the medium term as policy decisions and inflation impacts tend to lag each other. Looking forward, the BoE will remain attentive to incoming data and expects “inflation to remain around 5% through the majority of the winter period, and to peak at around 6% in April 2022.”
MSLF EURO LIQUIDITY FUND (LVNAV)
As expected, year-end provided a number of challenges for short-end money markets as the lack of collateral available for overnight reverse repo and the lack of balance sheet capacity for overnight deposits combined to make a historically difficult year-end for short-term rates. Overnight repo trades cleared as low as -7% while even the more stable deposit rates went through the -1% barrier. Given this, much of the investment in December was about re-allocating liquidity from overnight into weekly liquid eligible assets such as government agency and treasury bills. Most of this was done with a short maturity focus, in 1-month or shorter bills. Opportunities outside these trades were therefore limited as bank issuance dried up in the run-up to year-end, and only a limited number of assets were purchased in either money market instruments or tail-end bonds. Given the rate environment, we continued to see investors choose to utilise money market funds as their preferred year-end investment, taking the Fund asset size to around €12 billion by year-end.
MSLF STERLING LIQUIDITY FUND (LVNAV)
Following the surprise hold in November, the MPC’s duly delivered rate hike in December was a little against market expectations, and given the proximity to year-end, the impact of the 15 basis point hike was not immediately seen in short-end markets. Year-end pressures dominated with zero or negative yields still prevalent even after the hike. As is fairly typical in sterling markets, however, outflows in the run-up to year-end eased pressure on our overnight capacity constraints and meant the Fund did not have to trade at negative rates in overnight securities at year-end. The Fund’s assets under management ended the year at a record year-end high of £7.8 billion after reaching a high of £8.8 billion intra-month.
The WAM (weighted average maturity) and WAL (weighted average life) also rose due to the year-end outflows, finishing the year at 56 days and 68 days, respectively.
MSLF U.S. DOLLAR LIQUIDITY FUND (LVNAV)
On the month we purchased both fixed- and floating-rate securities, with fixed tenors in the first half of 2022 and floating-rate securities with maturities in the second half of 2022, that reset off of the SOFR index with coupons that will immediately reprice in the event the Fed hikes rates. Our portfolio ended the month with a WAM on the lower end of the peer group and with weekly liquidity on the higher end of the peer group near 60%.
MSLF U.S. DOLLAR TREASURY LIQUIDITY FUND (PUBLIC DEBT CNAV)
As we typically see at year-ends, supply constraints emerged from dealers on repo availability due to balance sheet limitations and from overwhelming demand for short bills by investors. Short-dated Treasuries rallied heading into the last week of the year as investor demand overtook attractive investment options overall. We took this opportunity to sell select Treasuries at attractive bids, reinvesting most of the proceeds into overnight repurchase agreements or bill auctions, to a lesser extent. Just before their holiday recess, Washington legislators agreed to a procedural path to resolve the debt ceiling. The debt limit was increased by $2.5 trillion and pushed off another episode until after the midterm elections. This allowed the U.S. Treasury to increase supply heading into year-end, which moved auction stop-out yields slightly higher on supply increases. Market expectations continued to rise in anticipation of multiple rate hikes in 2022 by the FOMC and on their action to speed up and end asset purchases in March 2022. The portfolio’s duration fell during December as we sold the aforementioned positions and structured the portfolio for expected multiple rate hike actions in 2022. We continued to manage the portfolio to be responsive to changes in market conditions and interest rate levels.
The net performance data shown is calculated net of annual fees. The sources for all performance and Index data is Morgan Stanley Investment Management. Please visit our website www.morganstanley.com/im to see the latest performance returns for the fund’s other share classes.