What does the Fed’s hiking cycle mean for the risk free rate?
We’ve been talking a lot over the last few months about the risk-free rate. That’s because it’s been moving in a direction we haven’t seen for a while - up. The 3mth US dollar interest rate* is now 2.3%, up from 1.3% in September. It was <0.5% for most of the period from 2009 to 2015.
The risk-free rate is important because it’s the rate of return against which the return on any other (risk) asset is judged. If an asset with risk doesn’t offer a sufficient excess return, then investors will logically invest risk-free.
In the aftermath of the financial crisis, monetary policy has been aimed at encouraging investment in risky assets through suppressing risk-free returns, either through low/zero policy rates or through quantitative easing. The chart below suggests the impact this has had on risk-free investment. The red line shows the annual change in the level of assets under management in US dollar money market funds. After the Fed slashed rates to 0-0.25% in 2008, US money fund assets fell sharply, from almost $3.8tr to about $2.7tr. From 2012 to 2016, assets barely moved, growing by an average of just $7bn a year.
With the Fed’s hiking cycle, this has started to change. Assets grew by $120bn in 2017 (but at $2.8tr they remain far below the 2008 level). That’s $120bn that didn’t go into the bond market or anywhere else in the risky asset universe. The 3mth US dollar rate has risen another 60bps since the end of 2017. As Paul Causer has said to many clients, a lot of capital has been misallocated over the last few years. It will be interesting to see how much might be re-allocated to cash, and the consequences of this across the risk spectrum, now that the risk-free rate is less prohibitive.
USD 3 mth rate (%, lhs) v US Money Market AuM growth (USD bns, rhs)
Source: Bloomberg and the Investment Company Institute latest available data as at 26 March 2018
*ICE LIBOR USD 3 Month
*ICE LIBOR USD 3 Month
