First American Money Market Funds

What market conditions had a direct impact on the bond market this quarter?

The second quarter was highlighted by strong U.S. Gross Domestic Product (GDP) growth, higher than expected inflation data and continued monetary accommodation from the Federal Reserve (Fed). Inflation data and concerns the Fed is behind on the policy curve have been key drivers of market and yield curve gyrations.

Economic Activity – Second quarter (Q2) GDP is expected to reflect a robust 9% to 10% growth rate as the economic reopening expanded and healthy consumers increased their spending. Current forecasts are for Q3 and Q4 growth to remain at a healthy 7% and 5% clip. Non-farm Payrolls added 1.702 million jobs in Q2, but still lag February 2020 total payrolls by 6.764 million jobs. The 5.9% U3 Unemployment rate seems to be understating labor market tightness, illustrated by the historically low U.S. Job Openings by Industry total of 9.209 million positions vs. Total Unemployed Workers in the Labor Force of 9.484 million. Anecdotal evidence suggests labor participation has been hindered by enhanced unemployment benefits scheduled to expire in September. June’s ISM Manufacturing and ISM Services readings of 60.6 and 60.1, respectively, are off recent highs but still indicate strong growth. For context, any reading over 50 indicates sector expansion. The expected rise in the Consumer Price Index (CPI) has exceeded expectations with year-over-year prices jumping 5.4% and CPI ex food and energy rising 4.5%. The Fed’s preferred inflation index – the PCE Core Deflator Index – grew a more modest, but still elevated, 3.4% year-over-year through May. Inflation expectations measured by the five-year TIPs vs. Treasuries ended the month at 2.5%, noticeably above the Fed’s 2% average inflation target.

Monetary Policy – Despite rising consumer prices and growing concerns the Fed is behind the inflation curve, the Fed remained steadfast in its views inflationary pressures are transitory and related to supply dislocations created by COVID. As expected, the Fed maintained its 0.00% to 0.25% federal funds target range, but the June 16th Dot Plot did indicate the majority of Fed officials believe the first rate hike will be in 2023 rather than 2024, as signaled in the March 17th report. The Fed has clearly begun “thinking about thinking about” tapering its $120 billion monthly asset purchases with actual reductions expected by year-end. In June, the Fed lifted the administrative rates for the Fed NY Reverse Repo Program (RRP) and Interest on Excess Reserves (IOER) by five basis points (bps) to 0.05% and 0.15%, respectively. The rate increase has helped keep short market rates from going negative and allowed the money market fund (MMF) industry to absorb excess liquidity in the system through the massive increase in RRP usage by MMFs.

Fiscal Policy – After passing a $1.9 trillion COVID relief package in March, the Biden Administration and Democratic-controlled Congress are pushing for a multi-trillion dollar plan to address the country’s infrastructure as well as funding many traditional Democrat priorities. President Biden is proposing to pay for his plan with tax increases, including an increase in the corporate tax rate from 21% to 28%. Republicans have countered with more modest proposals in the $600 - $800 billion range focusing specifically on traditional infrastructure such as roads and bridges. Markets are debating the value of further stimulus into a rapidly expanding economy and its potential impact on inflation. The suspension of the U.S. debt ceiling is set to expire in July, and to date, there has been little progress addressing the issue in Washington or in the press. While the possibility of a technical default of U.S. Treasury debt is extremely low, the debt ceiling does have implications for Treasury debt issuance and continued drawdown of the Treasury’s General Account (TGA).

Credit Markets – After passing a $1.9 trillion COVID relief package in March, the Biden Administration and Democratic-controlled Congress are pushing for a multi-trillion dollar plan to address the country’s infrastructure as well as funding many traditional Democrat priorities. President Biden is proposing to pay for his plan with tax increases, including an increase in the corporate tax rate from 21% to 28%. Republicans have countered with more modest proposals in the $600 - $800 billion range focusing specifically on traditional infrastructure such as roads and bridges. Markets are debating the value of further stimulus into a rapidly expanding economy and its potential impact on inflation. The suspension of the U.S. debt ceiling is set to expire in July, and to date, there has been little progress addressing the issue in Washington or in the press. While the possibility of a technical default of U.S. Treasury debt is extremely low, the debt ceiling does have implications for Treasury debt issuance and continued drawdown of the Treasury’s General Account (TGA).

Yield Curve Shift

^{*The three-month to ten-year portion of the yield curve flattened 29.7 bps to 142.7 bps, due almost entirely to the 27.2 bps decline in ten-year yields. Three-month yields are expected to remain near the RRP rate of 0.05%, while ten-year yields influenced market confidence on the reflation trade, inflation expectations and guidance on future Fed asset purchase policies.}

Duration Relative Performance

^{*Duration estimate is as of 6/30/2021}

^{ICE BofA Treasury Index Definitions}

Benchmarks with exposure to maturities two years and less had little performance impact from yield curve moves. Benchmarks with exposure to securities maturing in the five-year and longer benefitted from declining yields.

Credit Spread Changes

^{ICE BofA Index definitions}

^{Option-Adjusted Spread (OAS) measures the spread of a fixed-income instrument against the risk-free rate of return. U.S. Treasury securities generally represent the risk-free rate.}

Corporate credit spreads declined across the board, with lower-rated corporate credit outperforming their higher-rated peers. Credit in general benefitted from an improving economic outlook and, by extension, improved credit conditions and strong technical factors.

Credit Sector Relative Performance of ICE BofA Indexes

^{ICE BofA Index definitions}

^{*AAA-A Corporate index outperformed the Treasury index by 21.8 bps in the quarter.}

^{AAA-A Corporate index underperformed the BBB Corporate index by 30.0 bps in the quarter.}

^{U.S. Financials outperformed U.S. Non-Financials by 7.4 bps in the quarter.}

With credit spreads already at or near historic lows, credit’s strong Q2 performance was impressive and mildly unexpected. Financial credit outperformed their industrial counterparts..

What were the major factors influencing money market funds this quarter?

The second quarter of 2021 continued on a positive tone with COVID-19 vaccinations gaining momentum, strong economic data and overall market optimism continuing to spread. However, front-end yields remained challenged as technical forces pushed additional cash into the system coupled with the FOMC’s stimulative monetary policy. The money market industry remained flush with cash while U.S. Treasury bill and Repo levels remained entrenched at the bottom of the FOMC’s fed funds rate target. The Fed made key technical adjustments to the IOER and RRP, providing five bps of rate relief as the RRP continued to absorb excess cash with the facility nearing $1 trillion by quarter end.

First American Prime Obligations Funds

Credit spreads remain tight, reflecting the trading ranges and yields one should expect in the current low rate environment. Considering an uncertain regulatory backdrop, a flat yield curve and a conservative approach to cash flows, the fund was positioned with strong portfolio liquidity metrics influenced by fund shareholder makeup. Management continued to employ a heightened credit outlook maintaining positions presenting minimal credit risk to the fund’s investors. Under the current market conditions, the main investment objective was to maintain liquidity and judiciously and opportunistically enhance portfolio yield based on our economic, investor cash flow, credit and interest rate outlook. We believe the credit environment and relative fund yields make the sector an appropriate short-term option for investors.

First American Government and Treasury Funds

Treasury and government funds continued to see inflows as monetary system cash balances grew. Treasury Bill / Note supply decreases resulting from the reduction in U.S. Treasury general account pushed Government-Sponsored Enterprise (GSE) and Treasury yields to a trading range near the bottom of the FOMC’s fed funds target. Management continued to focus on securing incremental long-term yield when rangebound trading opportunities arose, seeing little downside to extension, anticipating a low yield environment for the foreseeable future. Throughout the quarter, we also capitalized on opportunities in floating-rate investments that made economic sense and felt would benefit shareholders over the securities holding period. We anticipate that investment strategy will remain constant until we near the end of the Fed accommodation cycle.

First American Retail Tax Free Obligations Fund

Investor redemptions from tax-free money funds have continued at a steady pace. The near-zero rate environment and the income tax payment deadline in May combined to fuel the recent outflows. As of mid-year, overall municipal money market fund assets have declined by more than $13 billion. Flows into municipal bond funds, however, have provided an offset. Reinvestment from municipal bond maturities and coupon payments, which tend to be at the highest levels during June through August, is expected to keep demand for municipal securities strong. Supply in the front end of the curve has been slim. Municipalities received the first round of payments from the American Rescue Plan in May. This money is likely reducing short-term financing needs, and we observe that municipal note issuance is, in fact, down around 25% year-to-date vs. 2020 levels. In addition, we have witnessed several issuers choosing to pay down commercial paper maturities rather than roll this debt. As market conditions permit, the fund is still motivated to pursue strategies with a longer weighted average maturity and higher allocations to fixed-rate investments vs. its peers.     

What near-term considerations will affect fund management?

In the coming quarters, yields will stay depressed as the U.S. progresses through the impacts of the COVID-19 pandemic and the FOMC’s commitment to easy monetary policy. It appears the yield on non-government debt has bottomed, but supply / demand imbalances resulting from excess system liquidity could push yields marginally lower. We believe that prime money market fund yields are near a floor as pre-pandemic holdings have matured and the Fed has re-established a floor on short-term yields. The institutional and retail prime obligations funds will remain reasonable short-term investment options for investors seeking higher yields on cash positions while assuming minimal credit risk.

Yields in the GSE and Treasury space will remain influenced by Fed policy and Treasury bill / note supply. The Fed has demonstrated they will provide the tools necessary to normalize the repo market, foster market liquidity and keep front-end rates above zero. Moving forward, assuming no additional Fed policy adjustments, we anticipate T-bill / note issuance to decline, providing the sector with further challenges to invest large balances efficiently outside of the RRP. Any unexpected supply changes in Treasury issuance may create some yield volatility on the front end as the forces of supply and demand seek optimization. Management will continue to capitalize on investment opportunities, in all asset classes and indexes, based on domestic and global economic market data as well as changes to Fed rate expectations.

For more information about the portfolio holdings, please visit:

https://www.firstamericanfunds.com/index/FundPerformance/PortfolioHoldings.html

Sources

Bloomberg