Federal Reserve Board¹
The Federal Open Market Committee (FOMC) voted unanimously to increase the federal funds target rate by 0.25% to a range of 4.50% to 4.75% at the conclusion of its February meeting. The committee noted that further rate hikes are “appropriate” in order to achieve “sufficiently restrictive” policy. The FOMC modified their messaging: the post-meeting statement. It had previously discussed the “pace” of future rate increases, but now refers to the “extent” of future increases. This change doesn’t seem overly impactful on the surface, but it points to a Fed that is beginning to approach the end of its rate hiking cycle. Fed officials continue to monitor the economic outlook in effort to position policy accordingly. Market participants expect the Fed to continue raising rates into early summer, as January’s employment figures far exceeded expectations.

European Central Bank¹
At the European Central Bank’s (ECB) policy meeting on February 2, President Lagarde and the policy committee increased the ECB deposit rate by 0.50% to 2.50%. The ECB illustrated that it intends to continue raising rates in March by 0.50%. Subsequently, the committee will reevaluate the path of monetary policy. The central bank stressed the importance of keeping rates at “restrictive levels” for longer to avoid another flare-up of inflation and shifting projections in the wrong direction.

Bank of England¹
The Bank of England (BoE) Monetary Policy Committee (MPC) voted 7-2 to increase the Bank Rate by 0.50% to 4.00% at its February meeting. The two dissenting members preferred to keep the rate unchanged at 3.50%. While December inflation posted at 10.5%, the BoE expects inflation to fall towards 4% by year end. The committee noted inflation is beginning to turn, but the labor market remains tight and price and wage pressures are still present. Risks remain elevated as economic indicators point to a higher risk of entrenched inflation.

PORTFOLIO STRATEGY

Government/Treasury Strategy
Debt ceiling considerations have started to percolate through our market, and will continue to do so as the year progresses. Currently, it is still early in the process with new information coming out each week. While liquidity remained ample with plentiful supply, it is likely to be volatile amid the debt ceiling negotiations. Reverse repo (RRP) balances remain high and there is capacity to extend if needed.

Auctions in January have been taken down surprisingly well, despite the massive increase in issuance of short-dated bills early in the month. RRP has fallen from its peak levels as funds have gently moved into some of this cheaper collateral and the Fed stepped down to a 25 basis point hike on February 1. The 6-month auctions will be important to watch as we expect their maturity dates will start to fall in late summer/early fall, the likely period for debt ceiling fireworks. So far this year, we have not seen signs of stress in these auctions.

Additionally, Fed policy remains paramount to our market. Although the Fed downshifted to a 25 basis point hike at its most recent meeting, the path forward is unclear. The direction of inflation as depicted by incoming data will impact the Fed’s posture meeting by meeting.

The market is starting to show signs of a full shift from being enamored with inflation to being enamored with dis-inflation. Investors outside of money market funds have become more comfortable adding duration. However, we believe the Fed has more work to do to bring inflation to its target, and while we continue to add yield opportunistically within the scope of our duration view, we think prudence is still warranted.

The portfolios’ weighted average life (WAL) slightly increased as we looked to opportunistically add Treasury floating-rate note (FRN) exposure and incremental SOFR (secured overnight financing rate) FRN agency exposure. In the Treasury Securities portfolio, we lengthened weighted average maturity (WAM) heading into January, allowing us to avoid the year-end richening in short-maturity bills, and then rolled that paper back on the curve throughout January as supply increases cheapened 1- to 3-month paper. By the end of the month the Treasury Securities portfolio was back in line with our peers on WAM/WAL. In the Government funds, we added some small positions to our fixed-rate agency debt exposure late in the month.

Prime Strategy³
In January, spreads continued to rally after year-end and stabilized towards mid-month. Throughout the month, we allowed the portfolios to organically roll down with zero opportunity cost. Weighted average maturities (WAMs) increased slightly as periodic dislocations in pricing provided opportunities in the 6-month and longer tenors. Overall, market liquidity remained stable in the month, with ample supply and unconstrained dealer balance sheets.

Monetary policy remains the key driver of portfolio composition and positioning. We still think daily resetting floating-rate notes offer the most attractive opportunity because their coupons continue to reset higher as the Fed tightens monetary policy, while also remaining at an elevated level once the Fed reaches the terminal rate. Floating-rate notes can also offer a buffer from interest rate risk, as coupons will continue to reset if the Fed tightens by more than anticipated by the market.

Tax-Exempt Strategy
Short-term municipals saw a dramatic richening of valuations in January after experiencing a spike in rates in December. As we head into tax season, rates will likely rise as investors sell tax-exempt money funds to raise cash to meet tax payments.

Municipal credit quality continues to remain solid, and higher employment, increasing wages and rising property values have all served to bolster tax receipts. In general, municipal bonds as an asset class are also considered more defensive than most others during times of economic stress. State and local governments budget in advance, and it takes some time for economic downturns to start affecting their balance sheets – even more so for local municipalities that rely heavily on property taxes. Housing property tax receipts typically decline years after economic shocks, as it takes time for home values to be reassessed.

Uncertainty around the Federal Reserve, the Treasury market and the geopolitical landscape will likely continue to weigh on the market. Municipal yield movements are closely tracking the Treasury market’s high volatility, and it will likely require a calming of that volatility, as well as a more favorable technical municipal backdrop, to reignite persistent market conviction and sustained outperformance. As the Fed moves ahead with rate hikes based on potentially lagging economic data, the risk of a policy error grows.

We continue to place an emphasis on maintaining high levels of liquidity with diligent oversight of credit quality, portfolio maturity and diversification.⁴ In January we marginally extended the portfolio’s WAM as daily variable rate demand note (VRDN) rates dropped to a greater degree than weekly and tax-exempt commercial paper rates. Overall, we believe the portfolio is well positioned for a rising rate environment, with a short duration and high concentrations in variable rate demand obligations and floating-rate securities.

¹ Source: Bloomberg.
² Weighted Average Maturity (WAM): Measures the weighted average of the maturities of the portfolio’s individual holdings, taking into account reset dates for floating rate securities.
³ The Portfolio will be required to price and transact in their shares at a floating net asset value (“NAV”) and will be permitted to impose a liquidity fee on redemptions or temporarily restrict redemptions in the event that the Portfolio’s weekly liquid assets fall below certain thresholds.
⁴ Diversification does not eliminate the risk of loss.

The views and opinions expressed are those of the Portfolio Management team as of January 31, 2023 and are subject to change based on market, economic and other conditions. Past performance is not indicative of future results.