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Views 1092 Aug 9, 2023

Raising interest rates like a tiger, but money funds are expected to benefit?

Main points:

● Fed rate hike refers to raising the target range of the federal funds rate, which in turn affects the cost of mortgages, car loans and commercial borrowing, and reduces the risk appetite of businesses and ordinary people.

● money funds are expected to benefit from a rising interest rate environment, as they reflect short-term interest rates, have the opportunity to generate higher returns, and are more popular with investors in times of stock market volatility.

The Fed's interest rate decisions are often a big financial event and can hit the stock market, but money funds can become one of the good places for investors to deposit idle money, because the returns of money funds usually rise in the environment of raising interest rates. For example, Crane Data, which tracks money funds, shows that yields on money funds rose during the period from December 31, 2021 to June 30, 2022.

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Photo: money fund yields climb during the Fed's rate hike, source: Wall Street Journal, Crane Data

Why is this? Before we answer this question, we first need to understand what the Fed's rate hike is and what impact it will have.

Understand the Fed's interest rate hike

One of the main goals of the Federal Reserve, as the central bank of the United States, is to achieve price stability. Therefore, when inflation remains high, the Fed will take action to control it, mainly by influencing the target value of the federal funds rate.

The so-called federal funds rate is the rate at which banks lend excess money overnight. The Fed can buy and sell Treasuries to adjust market liquidity and influence the target value of the federal funds rate. The higher the liquidity, the lower the federal funds rate, and vice versa.

The Federal Open Market Committee (FOMC) meets eight times a year to discuss the target range of the federal funds rate. If the federal funds rate changes, it will also be passed on to other interest rates.

After the Fed announces an increase in interest rates, both business operations and the lives of ordinary people will be affected to a certain extent-corporate lending rates will rise accordingly, which in turn increases the operating pressure on enterprises, which may even be reflected in stock prices; although interest rates on bank savings will increase, the pressure on loans such as home loans and car loans will also increase, weakening consumer confidence.

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Photo: Fed interest rate hike transmission chain, source: federal Reserve Board

Three reasons why money funds may benefit from higher interest rates

1. Money funds can reflect short-term interest rates

According to the Federal Reserve, the interest rate of money funds is largely affected by changes in the federal funds rate. Money funds mainly invest in liquid short-term monetary instruments, which yield higher yields after raising interest rates.

two。 By participating in overnight reverse repurchase, money funds have the opportunity to get higher returns.

In order to recover liquidity from the financial system, the Fed may carry out reverse repos, selling securities to eligible traders, including some money funds, and promising to buy them back at a specified price on a scheduled date, according to SEC documents and Fed instructions. Some money funds can use excess cash to participate in overnight reverse repos and earn potential interest, according to Bloomberg.

3. Raising interest rates hits the stock market, highlighting the charm of the "safe haven" of money funds.

As the Fed raises interest rates, companies face higher operating pressure, stock markets become volatile due to tighter liquidity, investors bear higher borrowing costs and worry about job losses caused by the recession. At this time, money funds with relatively low risk and high liquidity have become a safe haven for funds.

Of course, not all money funds will benefit from the Fed's rate hike. Fed interest rate hikes usually mean that other currencies have depreciated against the dollar, and historically, the currencies of some emerging countries may even be hit.

Generally speaking, the Fed raises interest rates first in favor of dollar-denominated money funds (of course, in retrospect, the dollar did not continue to appreciate throughout the interest rate hike cycle); as to whether the yields of monetary funds denominated in other currencies will rise, it also depends on whether the region to which it belongs raises interest rates and the stability of the monetary system.

Disclaimer: The above content does not constitute any act of financial product marketing, investment offer, or financial advice. Before making any investment decision, investors should consider the risk factors related to investment products based on their own circumstances and consult professional investment advisors where necessary.

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