It’s Just Math
The current Federal Funds rate is 5.375. This is up from .125 in March of 2022.
In short, the Fed pays financial institutions this rate on their cash balances and thus it serves as the benchmark for all highly rated money market yields, including short T Bills.
The Federal Reserve has indicated that their fight versus inflation is almost over and that going forward, they are more likely to lower this rate, not raise it. In short, their tightening cycle is OVER.
In fact, at their December meeting, Fed Governors indicated that by 2024 year-end, the Fed Funds rate would be 4.625, which equates to three 25 bpt cuts (5.375 – .75 = 4.625). The Fed usually makes policy changes only at their scheduled meetings. Their upcoming meetings are scheduled for March, May, June, July, September, November, and December.
Lower inflation and lower short rates have received quite a bit of press. Of course, it makes sense to extend duration, if we can lock in attractive rates before the Fed start easing. Many investors have already started this process and have pushed yields in longer duration securities much lower than they probably should be, given the Fed’s current guidance. The December 2024 Fed Funds futures contract is trading at a yield of 4.125, which means the markets are pricing 5 eases (5.375 – 1.25 = 4.125), not 3. We think this is excessive and it has important ramifications on longer duration yields AND investment strategy.
As portfolio managers, we need to determine when its best to extend durations for our clients. To do this, we often look at implied forward rates.
As an example, let’s say our client has 200 dollars and she can either buy the current 6-month T Bill at a 5.30 yield and reinvest her maturing proceeds in six months’ time at the then market rate (which we don’t know), or she can extend duration NOW and buy the 12-month Bill at 4.80. Which is better?
If she buys the 12-month T Bill at 4.80, she will make 9.60 (4.80% * 200 = 9.60) for the year.
If she buys the 6-month Bill, she will make 5.30 for the first six months and will need to reinvest the maturing proceeds at a rate higher than (9.60 – 5.30 = 4.30) to earn more than 9.60.
Since the Fed indicated that they see the Fed Funds rate at 4.625 at 2024 YE, it’s probably a good bet that she will be able to reinvest her proceeds at a rate much higher than 4.30, so she is better off NOT extending (not buying the 12-month T Bill). If she could buy the 12-month T Bill at 5.00, then it would likely make sense to extend…..it’s just math.
