December 2018 – Monthly Commentary

December 2018

As we expected, the Federal Reserve lifted the overnight lending rate by 25 basis points in December and indicated that they would lift rates two more times in 2019, backing away from their forecast of more frequent rate hikes.  Also, as we expected, Fed Chair Powell gave a dovish assessment of the Fed’s view of the economy and markets.  However, that did little to calm investors, with December being another “bloodbath” for equity holders.  As measured by the S&P 500, stocks fell 9.20% for the month.  The period was challenging for fixed income as well, driven primarily by a widening in credit spreads.  The panic was so widespread that it seemed there was no place to hide from the selling.  However, despite the credit widening and loss of faith in the Fed, our Reserve Cash Management (RCM) strategy survived the market weakness and profited for the period.  Given that positive outcome, we would like to use this monthly update to give an overview of the RCM strategy.

As of year-end, we estimate that the reserve cash management (RCM) composite portfolio has a yield to maturity of approximately 3.24% and an average effective duration of 71 days.  We find the characteristics of the RCM particularly attractive given that the Barclay’s Aggregate Bond Index has a yield to maturity of 3.28% and an average duration of maturity of 6.2 years.  The Federal Reserve’s base case is for two additional rate hikes in 2019.  Thus, we think that short maturity portfolios continue to offer a better risk reward over the next 6 to 12 months.  

As we start the new year the 3-month LIBOR interest rate stands at 2.80%. Overwhelmingly, 3-month LIBOR is the reference rate for floating rate notes.  The increased volatility in the capital markets, and the reversal of Fed Chairman Powell’s hawkish tone from early October precipitated a shift out of floating rate notes and into fixed rate bonds.  An investor should be indifferent between holding a fixed rate note versus a floating rate note, if the expected return of each note is the same given the investor’s outlook for interest rates. 

Based upon trades that Halyard has observed in the market, there appears to have been indiscriminant selling in this space with floating rate paper trading at less than fair value relative to its fixed rate counterpart. Halyard believes this may be the effect of asset allocators shifting from floating to fixed rate coupon bonds using ETFs.  The allocators sell the ETF and then the ETF sells bonds to meet the redemption – often at levels below fair value.  While the ETF investor is expressing his interest rate view, the ETF’s are selling floating rate assets at price levels that seem to imply a sharp decline in LIBOR during the note’s average life – which seems inconsistent with the view of possible interest rate hikes in 2019. 

We favor floating rate paper maturing in 2019 and 2020.  Following the equity drawdown and Chairman Powell’s recent less hawkish tone, the Fed Fund’s futures market is no longer implying any interest rate hike in 2019 and a possible interest rate cut in 2020.   While we acknowledge the possibility of fewer interest rate hikes, we still see front end interest rates moving higher.  If the Fed’s base case for two additional interest rate hikes in 2019 comes to pass, 3 month LIBOR should move higher and possibly approach 3.25% by late 2019.  A further increase in LIBOR will increase the coupon income of floating rate notes.  In that scenario, we expect the yield on the RCM strategy to rise commensurately.

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