Last year, we sat down with Jeff Plotnik, Senior Managing Director of Funds Management, to discuss the outlook for money market funds in 2023. As a follow up to that interview, we spoke with Jeff again and examined what happened behind the scenes in 2023, as well as his outlook for 2024.

Were there any surprises in the money market fund space in 2023?  

The big surprises for money market funds (MMFs) really came in 2022 when then Federal Reserve (Fed) raised rates more aggressively than many anticipated. Early 2023 witnessed some yield dislocations for MMFs as they waited to exit underwater positions, and while 2023 brought plenty of volatility, I don’t think fund managers were caught off guard by any market dynamics other than perhaps the Silicon Valley Bank failure. This is reflected by the tight yield ranges – 1 to 3 basis points (bps) between MMFs -- especially in the Treasury and government funds where credit is not a component.

The last time we spoke, you mentioned that timing extension trades was one of the main challenges facing money fund managers. How did 2023 play out in this respect?  

The extension play is well underway in MMFs, beginning in earnest in Q4 2023 with government and Treasury funds now reporting weighted average maturities (WAM) around 40 to 45 days. The effectiveness of MMFs’ strategies to increase portfolio durations will become more apparent as the Fed begins it easing cycle this year.  While the timing of when easing begins is debatable, funds that are caught short could be at a yield disadvantage later in the year.  

What impact does the Fed’s evolving policy on interest rates have on money market funds?

 I think the important thing to stress is that it is expected that rates will be coming down this year, and consequently, so will money market fund yields. But until inflation gets closer to its 2% target, it is possible that Fed policy will remain restrictive, in historical terms, in relation real rates. In my opinion, money market funds will remain an attractive short-term investment option to investors.

For context, 2023 saw money market funds draw record inflows, hitting an industry high of nearly $5.9 trillion. When the Fed started the tightening process in 2022, there was substantial liquidity to drain from the system before money market fund assets would see any real pressure. The initial impact was the Fed RRP being reduced from around $2.3 trillion to under $600 billion. For the most part, this involved funds substituting RRP for marginally cheaper Treasury bills and street/dealer repo. Market events like the regional banking crisis crated a flight to quality catalyst for the asset class as well. All in all, 2023 was a conducive environment for asset growth in the MMF space.  

As the fed tightening cycle matures and most likely ends in 2024, the potential for MMF assets to decline will increase. It’s now only a matter of time before banks and MMFs start competing more directly for marginal deposits, as system reserves begin to decline to the Fed’s preferred level. There is also an incentive for investors, that are able, to extend short-end dollars ahead of the expected fall in interest rates. In short, absent a catalyst, I suspect money fund complexes will largely be competing for existing dollars rather than accommodating inflows from an unexpected increase in liquidity.    

What do you see happening in 2024?

We expect rates to fall in 2024, and our investment strategy is to invest as if the first rate cut will come at the May 1 or June 12 FOMC meeting, with two or three 25 bps cuts to follow by the end of the year. With a remarkably resilient economy, but the market far more dovish than the Fed, it is difficult to have conviction on exact rate cut timing.  Honestly, I believe that the best extension plays made for money market fund managers were made in late 2023 before the rate cut momentum really took hold. In any case, I expect 2024 to be a challenging year for MMF managers. There are potential headwinds in every direction, including Fed and global central bank policy uncertainty, multiple geopolitical events, worldwide elections, among others. The impact of timing trades to gain, maintain, or lose that marginal edge versus relative peer groups will be watched carefully by investors in the competitive money market space.