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Adapting to a shifting liquidity backdrop

5 June 2024 |
Many UK money market funds have been extending weighted average maturities as the BoE considers rate cuts.

UK inflation fell to 2.3% in April, its lowest level in almost three years and just shy of the Bank of England’s (BoE) target of 2%. The news may have helped spur Prime Minister Rishi Sunak into calling a surprise July election but the higher-than-expected figure – many economists forecast 2.1% – has dampened hopes that the BoE might cut interest rates in at its 20 June meeting.

While the BoE kept rates unchanged – at 5.25% – in its May meeting, it’s worth noting that the Monetary Policy Committee (MPC) was split, with seven members voting to hold and two voting for an immediate 25bps reduction, including Sir Dave Ramsden, one of three deputy governors, who typically align with the view of the governor.

Moreover, Governor Andrew Bailey’s dovish comments during the press conference – in which he suggested the market may be under-pricing the number of cuts this year – added to hopes a summer cut many be on the cards. Of course, investors have been down this road before. It’s worth remembering that while the consumer price index has fallen – it does not mean that the prices of goods and services overall are decreasing, just that they are rising less quickly.

At the time of writing, markets have priced in less than two 25bps cuts for 2024 (see Figure 1).

Figure 1: Implied overnight rate and number of forecast BoE hikes/cuts

As the chances of June cut diminish, the possibility of a 25bps reduction on 1 August becomes more likely. But the MPC still has to juggle a host of factors, which could further reinforce divisions over when to cut.

Prime Minister Sunak’s unexpected dash to the polls may have also been hastened by the UK economy exit from last year’s technical recession with faster-than-expected growth of 0.6% for the first quarter of 2024. UK wage growth, however, remained persistently strong in the three months to March despite a slowing jobs market.  The unemployment rate rose to 4.3% in the first quarter.

Moreover, while inflation has fallen sharply because of the drop in energy prices, many analysts expect it could rise again towards the end of the year on the back of rising oil prices.

Extending duration

Money market funds seek to preserve capital and maintain daily liquidity, while offering a competitive yield. Over the last nine months, as interest rates have plateaued out, investors in UK liquidity products have typically received a return comfortably above the return on two-year UK gilts1. An attractive premium without the relative capital risk.

Around the world, money market funds – whether sterling, euro or dollar-denominated – have gained sizeable inflows over last couple of years on the back of the sharp rise in rates. US money market funds hit an all-time high of more than US$6tn earlier this year2.

But as central banks limber up to cut rates this year, possibly as soon as June in the case of the European Central Bank3, many investors are naturally thinking about the need to extend duration. The development of money market funds over the last few years has seem them become an investment class in their own right – not simply a place for investors to park spare cash. Many liquidity products have been extending their weighted average maturities in response to the latest pivots in central bank policy, seeking out higher-yielding securities and paper further out the yield curve and maximising returns for investors, while at the same time offering same day access. Should central banks further delay cuts – or moderate easing plans – then investors may want to hold off moving out of liquidity vehicles too soon, and miss out on yield.

For more information on Federated Hermes’ liquidity solutions please click here.

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