The financial press loves to talk about whether the Federal Reserve will raise interest rates in June, July or later this year.  We think they will raise rates one more time either this month or next month.  Why?  Because they have to in order to save the money market industry.

If you recall, we were espousing that the Federal Reserve should have been raising interest rates 2 years ago.  At that time, we thought it was wise to begin to get interest rates back to normal and we thought the economy was strong enough (see below chart) and job growth was robust enough (coming in above 250,000 per month) to handle such an increase.  In our opinion, the Federal Reserve missed their opportunity.    The economy has slowed significantly since then.  If you look at the attached chart, you can see that quarterly GDP has trended downward the past 4 quarters and last quarter it was barely positive.  This is reflected in company revenues for the S&P 500 which have been negative for each of the past 6 quarters.  In the past, the Federal Reserve has raised rates to temper a robust economy which we currently don’t have.  So there has to be another reason for raising rates at this time.   We believe it is money market reform coming later this year.

The Securities and Exchange Commission (SEC), under pressure from the “Jedi Council” (created by the Dodd-Frank Act), will be instituting major reforms to the US money market system that take effect on October 14^th of this year.  Under these regulations, in order to maintain a stable net asset value (NAV) of $1, money market funds must have more than 99% of their assets invested in US Government instruments.  There are costs for running a money market fund.  For example, The Schwab Retirement Advantage Money Fund has an annual expense ratio of .61% (operating expenses of .26% and management fee of .35%).  Schwab, like many money market fund operators have waived a portion of their management fees for the past few years so that the net yield for investors the past few years is 0% and not negative.  In addition, these funds have bought higher yielding investments – like commercial paper from companies – to help defer the cost of running the fund.  In order to keep the $2.7 trillion dollar money market fund industry afloat, the Federal Reserve must raise interest rates so that it will cover the cost of running government money market funds.   Otherwise, money market funds will be a thing of the past.

Non-government money market funds will not go away, but will have two main differences from a Government fund: 1) NAVs will fluctuate along with the market value of the underlying assets and will no longer be held at a constant $1, and 2) the boards of these funds have the ability to impose restrictions preventing investors from accessing their money for up to 10 days as well as imposing liquidity fees if liquid assets in the fund fall below a 30% threshold.  Since most individuals view money market funds as a place to safely park cash, we would not be surprised to see most of the $1.2+ trillion invested in prime money market funds be moved over to government money market funds.

What does this mean for your portfolio?

Because the Federal Reserve will be raising rates for a different reason than a robust economy or rising inflation, we would expect a greater degree of volatility in the months ahead.  In addition, many large US companies will have to pay higher rates of interest on their commercial paper to attract investors, given the mandate to use government investments in a multitude of money funds.  Those higher costs will be reflected in lower earnings.  This is especially true since many companies have increased debt levels significantly since 2008 to buy back shares and pay higher dividends.  The high valuations of US large company stocks, in our opinion, don’t reflect this higher cost.  We currently have our lowest exposure to US large companies since the founding of our firm in 1992.  Adding a headwind of higher interest rate costs only adds to our conviction.

Sincerely,

Your THOR Team