Cash Managers’ Interest Rate Dilemma

Public money managers face a strategic dilemma today: They can stick with money market funds, local government investment pools, and ultra-short investments like repurchase agreements, all of which still pay the highest interest rates available today. Or they can look to 2025 and try to lock in less spectacular but still healthy long-term interest rates in anticipation of lower short-term rates next year if and when the Federal Reserve lowers its overnight rates, believing that inflation has been tamed.

The problem is that markets have already begun to anticipate lower interest rates next year, so longer maturities now come with lower yields. The “give up” trade is hard to explain to those who can’t see beyond their own noses.

This is about more than just the egos of state and local treasurers. Budget officials need accurate projections of interest revenue from operating funds, and some may even urge their treasurers to lock in rates now to prevent a sharp decline in interest revenue next year. Already, general fund interest revenue looks set to fall 10 percent to 15 percent in 2025, and it could get worse if cash reserves and federal grants are spent this year.

Meanwhile, debt managers must decide when is the best time to sell municipal bonds and bonds to both increase cash flow and improve capital. With trillions of dollars of public sector budget invested in money markets and interest income again accounting for a significant portion of revenue, these are not trivial decisions.

Earlier this year, market insiders expected the Federal Reserve to cut its overnight rate as many as six times in 2024, with the rate falling to 4 percent or perhaps even lower by Christmas. They got ahead of themselves: Inflation has been persistently stronger than many had expected, so the Fed has repeatedly refused to cut rates too early for fear of giving its monetary normalization efforts a false start. As a result, the overnight rate has remained unchanged for nearly 12 months. Meanwhile, longer-term government bond yields have fallen somewhat since April, highlighting what is known as an inverted yield curve, where shorter-term rates are outpacing longer maturities.

Historically, the yield curve has typically been upward sloping for most of each business cycle to compensate investors for the expectation that interest rates will rise as the economy grows and demand for credit increases. An inverted yield curve often appears later in the business cycle, when the Fed is forced to tighten monetary conditions as demand for credit surges to finance expanding productive capacity.

Another scenario that often forces an inverted curve is when inflation has spiked for some other, noncyclical reason and the Fed needs to step on the brakes to restore monetary and price stability — as it has done over the past two years after a bipartisan COVID-19 check-writing frenzy that pumped trillions of dollars into the economy to stave off a drastic pandemic-induced recession.

Assuming inflation rates continue to fall—which is still an assumption but is currently the baseline forecast in financial markets—the Fed should be able to gradually ease its tight monetary policy and may actually have to lower short-term interest rates in 2025 to avoid a collapse. As a result, the overnight fed funds futures market currently projects an overnight rate of just 4 percent by this time next year, down a full point from the current rate. At that point, the yield curve would be either essentially flat or even slightly sloped again.

What will the future bring?

In fact, the Fed’s rate cut postponement pushed the futures market back eight months on traders’ calendars. The cash market for T-bills and notes followed suit, but not at a mathematical pace. If the futures clairvoyants are right, it still pays to lock in slightly longer yields for maturities in 2025 while you can.

For municipal bond issuers, the first takeaway from this mental exercise is that long-term borrowing costs are unlikely to fall significantly next year, barring a recession that significantly lowers yields on all government bonds. The decision-making factors for public finance teams will therefore center on (1) the inflation rates they expect for construction projects relative to the cost of capital, (2) whether they can expect to see a modest return on investing unspent bond proceeds during the construction period, and (3) voter approval of new bond issues. Congress is unlikely to do anything for at least a year that will create a shortfall and thus lower municipal bond yields, unless it puts an end to private-activity bonds in the next tax bill.

The dilemma for those investing operating cash today is that there seems to be no professional benefit in sticking your neck out on longer maturities at lower rates if there are no benchmarks. That’s the typical perspective for insiders. For outside money managers, the main force that could push them into a longer-term structure is having a performance index with a long-term bias in the one- to three-year range that many of them use.

This may be a point in the market cycle where external managers have a structural bias against some extension of maturities, contrary to the strategies employed by internal cash managers. A selected treasurer who favors lower, longer maturities will suffer a reputational loss that external managers working with an indexed policy benchmark can reasonably offset if they perform in line with or slightly outperform that benchmark.

But those waiting for the Fed to actually cut rates may miss the coming rush to land on securities maturing next year. If short-term interest rates fall as quickly as futures markets are currently forecasting, there could be a revenue shortfall in their 2025 budgets that is not offset by falling spending. Prudent budget forecasts should document what the Fed funds futures market is currently forecasting, unless budgeters are informed by Treasury managers that a better interest rate structure has already been established through previous maturity extensions. In either case, such cooperation would be highly recommended, but to be fair, it is quite rare in jurisdictions with separate budgeting and Treasury functions.

The technical tool in this case is the public sector version of a “breakeven analysis,” which requires a simple calculation of what the reinvestment rate the treasurer must receive later would be if he invested twice—once now for a shorter period and again later—rather than taking just one longer maturity now. The “implied forward rate” calculation allows the investor to decide whether the market has already priced in future rate cuts to the point where there is no advantage in buying longer securities now. The math currently tells us that the cash market has not reached that crossroads, if today’s futures investors are right. Maturities between 12 and 20 months currently seem to offer the best value using this tool.

Politics and economy

Some treasurers have asked whether the outcome of the November federal election will have any bearing on all this. For state and city budget purposes in 2025, the answer is: it might, but not really that much until 2026. Normally, a divided federal government would hand the levers over to the Federal Reserve. But if either side gains enough control of Capitol Hill to trigger a new round of inflation in 2026 and beyond through some concoction of partisan spending, tariffs or tax cuts, interest rates could rise amid a sell-off in the bond market.

Politics aside, if the national economy unexpectedly slips into recession on its own because average consumers are overextended, neither side is likely to have much influence over money market rates next year. That will remain the domain of the Federal Reserve. If the economy collapses, the Fed will have no choice but to lower its overnight rates below the 4 percent already projected for next summer, and probably even lower. Neither side wants that outcome. Pension funds will be hit far harder next year by the November election than state and local operating budgets, as stock and bond markets react to the election results and all sorts of theatrics related to the 2025 tax code.

The only good reason to hold short maturities right now is the possibility that the U.S. economy is strong enough—and inflation is well above 2 percent—that the Fed will cut overnight rates just once or twice, leaving the yield curve still slightly inverted and allowing reinvestment later at rates in the high and mid-fours. Call this the “two (cuts) and done” scenario. This is not the mainstream economic forecast right now, but no one can rule it out without additional evidence of an economic slowdown.

That makes today’s money market crossroads an important time for clear communication between budget and cash management teams. Given the growing prospects of significantly lower interest rates next year, now would be a good time to document the money market decision matrix facing those who must make decisions about multi-billion dollar revenues. Budget makers increasingly face a Hobson’s choice between locking in a lower yield today or second-guessing themselves later. But that’s the real world of public finance: Policymakers sitting on the dock until November will likely find that their ship has already sailed without them as the cash and futures markets for the coming months finally converge.

RuleOpinion columns reflect the views of their authors and are not necessarily Ruleeditors or board. No information contained herein should be construed as investment advice.