Ease on down the road

Market outlook

• In our view, information contained in the Federal Open Market Committee’s (FOMC or the Committee) Summary of Economic Projections released at the December meeting suggests the Federal Reserve (the Fed) has likely concluded its hiking cycle, subject to incoming data.
• Based on this information, we also expect the FOMC will eventually move to adjust the federal funds rate lower in a gradual manner, should inflation continue to decline.
• T-bill issuance should resume in earnest during the first quarter of 2024, while utilization of the New York Federal Reserve’s overnight repurchase agreement program (RRP) should continue to contract in our view.

Q4 recap

• The FOMC maintained the range for the federal funds target rate at 5.25% to 5.50% during the fourth quarter, as it continued, in our view, to cautiously assess the effects of its policy firming to date. 
• In a statement¹ released in conjunction with the December meeting, the Committee reiterated that inflation “remains elevated” while adding that it has “eased over the past year.” The statement was also modified to acknowledge that “growth of economic activity has slowed from its strong pace in the third quarter.”
• The Committee also softened its outlook for future interest rate actions in our view, updating the December statement to note that “in determining the extent of ‘any’ additional policy firming that may be appropriate” to reduce inflation to its 2% objective, they will consider various factors including the amount of tightening so far and the lagged effects of monetary policy.

Consistent with the increase in government MMF assets across the industry, BlackRock government funds experienced net inflows during the fourth quarter.

Short-term Treasuries repriced throughout the fourth quarter, as the future path of monetary policy became clearer. The 1-month bill ended the period up 4 basis points to 5.60%, while yield levels on all other tenors declined, as the market began digesting Fed rhetoric and increasing the number of cumulative rate cuts expected over the course of 2024. 

The 6-month and 1-year T-bills hit highs during the fourth quarter of 5.60% and 5.49%, respectively, however, both tenors ended the quarter significantly lower at 5.26% and 4.79%, respectively.

Throughout the quarter, our focus was to ensure ample liquidity for any potential cash flow volatility. At the beginning of this rate hiking cycle, we preferred a below neutral profile across our government funds. With respect to adding duration, we are now targeting a slightly above neutral stance and view fixed-rate extensions as providing attractive valuation points now that the FOMC has moved to a balanced risk outlook and the macro-economic environment has stabilized relative to last year. At the start of the quarter, weighted average maturities (WAMs) in our government funds hovered near 21 days for repo-eligible funds and 45 days for non-repo funds. By the end of the quarter, these figures edged up to 36 and 46 days, respectively

Purchases throughout the quarter were mostly comprised of 2-month T-bills at an average yield of 5.41% and 4-to-6-month T-bills at an average yield of 5.47%. 

Since June of 2023, markets received approximately $2.2 trillion of new T-bill supply through the end of the year, with most issuance skewed towards the front-end of the curve. Additional robust supply is expected in the first quarter of 2024. 

While eligible funds continued to utilize the Fed RRP throughout the period, aggregate usage of the facility steadily declined throughout the period as investors who favored the Fed RRP as an alternative to short-dated government securities began to rotate into new Treasury supply post-debt ceiling resolution and dealer repo rates remained more attractive, in our opinion.

Consistent with the increase in assets of prime MMFs across the industry, BlackRock prime funds experienced net inflows during the fourth quarter.

Amid broader market volatility, we believe investors exhibited demand for prime funds to take advantage of the incremental yield and diversification. At quarter-end, the spread between institutional government and prime MMF yields was 0.20%.²

Tier 1 commercial paper (CP) outstandings increased by $25.7 billion over the quarter, to $441.7 billion. As expected, CP rates continued to reprice in line with expectations for the future path of monetary policy. Financial CP within our prime funds maturing in three months or less ended the quarter with an average yield of 5.42%.

Rates on money market deposit instruments remained relatively consistent throughout the quarter, as overnight rates averaged 5.31% and 1-week at 5.32%.³ Our prime funds favored these investments. Purchases during the period were primarily of certificate of deposits and time deposits, CP and overnight repo for eligible portfolios.

Although we favored a shorter-duration stance over the last several months to protect against interest rate risk, we have been more focused on adding short term credit to add duration where appropriate. At the beginning of the fourth quarter, target WAMs for our prime funds ranged from 35 to 40 days. At quarter end, our target range was 45 to 50 days, and the prime funds had an average daily liquidity of approximately 53%.⁴

In the fourth quarter, tax- exempt money funds saw net inflows, ending with approximately $122 billion in industry assets. Dealer variable rate demand note (VRDN) inventory averaged $4.5 billion for the quarter and ended the period at $1.9 billion, below the rolling 12-month average of $4.9 billion.

VRDN new issuance remained light as the municipal yield curve remained inverted out to 13 years. Year-end pressures led to dealers resetting yields higher as the Securities Industry and Financial Markets Association (SIFMA) Index, which represents the average yield on 7-day municipal floating- rate debt, fluctuated between 2.98% and 4.52%, marking the largest upward move since March 2020.
Ultimately, the SIFMA Index reset to 3.87% at year-end.

Within the fixed-rate space, yields in the US Treasury market experienced their largest decline in decades, while 1-year municipal bond yields and 1-year municipal note yields also fell dramatically over the quarter from 3.70% and 3.79% to 2.67% and 3.12%, respectively.

Municipal note supply remained subdued compared to pre-pandemic levels due to healthy issuer balance sheets, elevated rainy-day funds, remnants of fiscal stimulus and prior years of low interest rates where issuers took on longer durations.

Our municipal money fund WAMs were positioned in the 5- to 10-day range with high levels of daily and weekly liquidity.

Looking ahead, while the municipal credit cycle has peaked, we believe that high reserves will cushion softer state and local revenue collections. In our view, while municipal fundamentals will remain sturdy, and most issuers are well positioned to absorb the impact of an economic contraction, we do expect municipal issuance to increase in 2024 due to a reluctance to raise taxes, an unwillingness to cut programs, a preference to maintain liquidity and a build-up of deferred maintenance.

Consistent with the theme across the ultra-short bond industry in 2023, the BlackRock Short Obligations Fund experienced net outflows throughout the fourth quarter.

Tier 1 CP outstandings increased by $25.7 billion to $443.8 billion during the quarter. Tier 2 CP outstandings increased by $17.3 billion to $105.2 billion at the end of December.

Yields in the Investment Grade (IG) space were volatile throughout the quarter, with the yields on the JULI 1-to 3- year ex Emerging Markets Index ranging between 5.00% and 6.23%.

In the first month of the quarter, IG spreads widened modestly, and yields moved higher, driven by increasing rates. During the remainder of Q4, as demand increased and Treasury yields moved lower, spreads tightened moderately. Financial spreads outperformed non-financials over the end of the quarter, as investor demand for the sector continued following the first quarter’s banking events.

IG issuance remained elevated in October and November, but significantly declined as December is a historically low issue month due to year-end balance sheet rebalancing. Overall, investors continue to assess the Federal Reserve’s path of monetary policy and the outlook for economic growth.

Throughout the quarter, our focus was keeping the fund well positioned by focusing purchases on CP maturing between 1-week and 2-months at yields ranging from 5.49% to 5.64%. Other investments consisted of selective purchases of 2-to-3-year corporate bonds at yields ranging from 5.40% to 6.04% and 6- to 12-month CP at a 5.81% yield.

We largely believe that the Fed has reached the endpoint of their aggressive hiking cycle; therefore, we look to maintain a neutral to long duration bias to lock-in income via longer rates and IG securities where attractive valuations present themselves.