KATHY JONES: I'm Kathy Jones.
LIZ ANN SONDERS: And I'm Liz Ann Sonders.
KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week we analyze what's happening in the markets and discuss how it might affect your investments.
Well, Liz Ann, we've seen all the headlines about the Dow and the NASDAQ hitting record highs in the past week. Give me your take on what's driving this.
LIZ ANN: Well, we're in a bull market, and stocks tend to do well when we're in a bull market. No, but you know, momentum does feed on itself. But I also think that earnings season was fairly supportive. It wasn't a great season in terms of top-line growth, but bottom-line growth, some of the metrics that are watched carefully, like the beat rate and the percent by which companies beat, were better than both recent and longer-term averages. Looking now at a double-digit likely gain for earnings in the first quarter, which is well better than what was expected. And even a turnaround in earnings back into slight positive territory for small caps, I think that's helped. You know, on your side of the world as a partial driver of equities, you had the recent move down from about 4.7 on the 10-year to 4.3 at the recent low, and that has proven to, at least in the short term, often be a tailwind for stocks, and there just is still enough liquidity out there to continue to be an important force behind equities.
KATHY: So speaking of drivers of the equity market, today we're talking about money market funds, and people often refer to money in money market funds as "money on the sidelines," just waiting to go into the stock market. What are your thoughts on that?
LIZ ANN: I tend to bristle a little bit when I hear that "money on the sidelines" or other expressions like "more buyers than sellers." For every buyer of something, there's a seller, and vice versa. And I'm not sure we can think of the money in money market funds as "sideline" money that is imminently going to find its way into the equity market. You and I have talked about this. It's very much an asset allocation decision, and it's in an asset class that actually has yield now.
And I think probably a lot of that money is fairly sticky and not necessarily poised to jump into the equity market. And back in the ZIRP days of zero interest rates, many investors that wouldn't otherwise have been inclined to step way out the risk spectrum had to do it in order to get any kind of pickup in yield and had to venture into the equity market to find that or riskier areas of the fixed income market. So that doesn't mean some of that money couldn't find their way into equities, but I don't view it as some $6 trillion imminent source of additional fuel for the equity markets.
KATHY: Yeah, it's almost like we're back to the future, right? You know, there used to be yield in short-term investments like this, and now there's yield again. So I think, yeah, we should probably expect there to be some allocation there.
LIZ ANN: Absolutely. So we are talking money market funds this week, and cash has been a big topic in the past year or two as rates have gone up and remained high. So tell us about our guests this week, Kathy.
KATHY: Sure. One advantage we have at Schwab is that if we want to talk to someone who runs a money market fund, we have a whole team of people we can ask about that.
And we have two guests joining this week. Linda Klingman is a managing director and head of money market strategies for Schwab Asset Management. She leads the portfolio teams for taxable and tax-exempt Schwab money funds and has overall responsibility for all aspects of the management of the funds. Prior to Schwab, which she joined in 1990, she was a senior money market trader with AIM Management, Inc.
She's managed money market funds since 1988, so she's seen a lot. And I'm also joined by Lynn Paschen. Lynn is a senior portfolio manager for Schwab Asset Management. She's responsible for the oversight and day-to-day management of the government and Treasury Schwab money funds. Prior to joining Schwab in 2011, Lynn held a number of positions in American Century Investments. She was most recently a portfolio manager and, from 2000 to 2003, worked as a fixed income trader.
Linda and Lynn, thanks for being here today. I think this is going to be a really interesting conversation. Let me start with this question—and maybe Linda, I'll shoot it to you first—what is a money market fund? When I look at Barron's or Schwab.com, I see this whole long list of things that have names that sound like money market funds, but what exactly is a money market fund?
LINDA KLINGMAN: All right. Hi, Kathy. Thank you for having both myself and Lynn today.
So a money fund—it's a mutual fund. It invests in debt securities that are very high quality with very short maturity. So our investment horizon is 13 months and in. So again, we're at the very short end of the market. A couple other things about money market funds—they're either taxable, or they're tax exempt, depending on the types of securities in which the fund invests. And there's actually—you know, with all the different names that are out there—there's three different types of money market funds. There's prime funds. There's government funds. Both of those are taxable funds. They generate taxable income. And then there's municipal funds. Going a little deeper, prime funds invest in the debt issuance of financial institutions, such as banks. And then government funds invest in U.S. government debt, such as Treasury bills and U.S. government agencies like Fannie Mae or Freddie Mac. And then on the municipal side, those funds are investing in securities that are issued by states, local governments, municipal agencies, such as school districts, water districts, things like that. So that's kind of the high-level kind of overview of what a money fund is and the type of investments that we're investing in.
KATHY: So usually people use these for liquidity, right, to have available cash. At least that's how I think of them. But it used to be, when I was young, and I remember starting out in this business, that they weren't that commonplace. People just kept money in the bank. So can you give me a little history of how they actually materialized?
LINDA: Yeah, absolutely. So this is kind of interesting. They've been around since the 1970s, and they came about in response to what's called Regulation Q. And at the time Regulation Q prohibited banks from paying interest on, like, checking deposits. And then they also capped interest rates on other accounts like savings accounts. And so money market funds were developed as kind of an alternative to this Regulation Q. And so again, they kind of started in the 1970s, and they've really grown since then. Right now, they're very popular because the Fed had rapidly raised interest rates over the last couple years, and money market funds in several cases are paying over 5% in interest. And so again, we've had a real resurgence in interest in money market funds. Again, as you said, it's an opportunity to earn a nice return on your cash. The objective of a money fund is to provide stability of capital, liquidity for shareholders, and then also a stable NAV, or net asset value, of a dollar.
KATHY: I remember them really getting popular in the '80s when interest rates soared. And yeah, that Reg Q had capped what you could get in a bank account or a savings account. So people all shifted into the money market funds. So Lynn, I'm going to go over to you with this question. And again, this is just a broad general question, but you're managing this money market fund. What do you do? How does one manage these very, very short-term investments?
LYNN PASCHEN: Yeah, that's a great question. So as portfolio managers on the money market funds, we are the investment decision makers. So we select the investments for the portfolio. We develop and implement the investment strategy to meet the stated goals and constraints of that specific portfolio. As Linda mentioned, there's these three different sectors. And depending on the fund, they all have different mandates and different characteristics associated with them.
Also, we execute the trades. We make the decisions on what we're going to buy or sell for the portfolio. And sort of the overarching theme there is we're monitoring the economic developments in the broader economy. We follow very closely and anticipate movements by the Fed, given these are short-term products, and those short-term rates set by the Federal Reserve Bank are closely aligned with what the investors are earning on these products. So those decisions that we're making are based on the outlook for the path of interest rates and all of the things in the broader economy—the state of the economy, any headwinds or tailwinds that exist. That could be with unemployment, inflation—which is a big topic, of course, right now—and growth in the economy. So you know, and on top of that, you've got any sort of supply and demand factors that could impact those securities in which we invest in the portfolios as well.
KATHY: So your latitude, though, is fairly limited if you're only going to 13 months, right?
LYNN: That is correct.
KATHY: So it doesn't sound like you have a huge amount of range in there in terms of duration, but it also sounds like you don't have a lot of range in terms of credit quality, right? If you're prime, you're in one set. If you're municipal, you're in another set. And if you're, of course, in government, you're all government-backed bonds. Do I have that right?
LYNN: That is correct. Money market funds are a highly regulated product. We do have rules around such things that you mentioned, such as maturity, the duration of those securities we add, the credit quality of the securities that we can invest in, as well as we have diversification requirements, meaning you can't be too concentrated in a specific credit. And last but not least, our very stringent requirements on the liquidity that we are required to have in the portfolios. In the current environment, it is now at fifty percent in weekly liquid assets, meaning fifty percent of the portfolio is required to be able to be converted to cash within seven days.
KATHY: Oh OK, so that really is important, I think, for investors to take in so that they know the most important thing is they can get their money when they need to get their money. That's a regulation, it sounds like.
LYNN: Yes, correct.
KATHY: So Linda, maybe go back to you on this one. I know that there are money market funds for retail investors, and there are money market funds for institutional investors. How do they differ?
LINDA: Yes, exactly. So retail money market funds are money market funds for what they call "natural persons." So that's the individual investors. So you, me, again, are kind of the retail set. Those money market funds that are geared towards retail investors are transacting at a dollar, so amortized cost means if you put a dollar in, you should be expected to get a dollar out. That's not guaranteed, but I can tell you the portfolio managers work very hard every day to make sure that stability of capital and that, again, if you put a dollar in, you should be expected to get a dollar out plus interest based on where interest rates are.
Institutional funds are geared towards, again, kind of institutional investors. These are going to be corporations, hedge funds, just again, the larger institutions that are investing in the market. And institutional money market funds maintain an NAV very close to a dollar, but there can be some ever-slight fluctuations again, because it's based on market pricing. Those are really kind of the general two aspects. The other thing I guess I would add is that there are prime retail and institutional money funds and there are municipal retail and institutional money funds. The government funds do not have that specification. They are available to both retail and institutional investors.
KATHY: Lynn, do you have anything since you're kind of hands-on doing this every day? Do you have anything to add on that side?
LYNN: You know, not really a lot to add. Linda covered most of the big differences there.
If you think about the institutional space, because there are these large corporations with extremely large balances, there's a little bit more variability and higher probably levels of liquidity given the more significant in-and-out movements in those portfolios. That's probably the other characteristic I would mention.
KATHY: So the manager managing that portfolio, those institutional portfolios, has to worry about one day some big company comes in or some big hedge fund and says, "Oh, I need $300 million today or as soon as possible," right?
LYNN: Yep, exactly.
KATHY: Whereas for a retail investor, that's not likely to happen. Most of us are not sitting on huge amounts of capital in money market funds. At least I hope not.
LYNN: Yes.
KATHY: I kind of think that might be a strange investment strategy for an individual who is so lucky as to have that amount of money. OK. That's really good to know because one of the questions I get a lot is, you know, "Will they break the buck? Will it go below a dollar?" And what you're telling me is that one of the primary objectives that you have is to prevent that from happening for your retail clients, correct?
LINDA: Yeah, the investment objectives of a money fund, you know, they're very clear. It's again—provides stability of capital, so maintaining that dollar NAV. Make sure that we have ample and sufficient liquidity if our shareholders are to, you know, redeem out of the funds. So we manage that very closely every day along with the NAV. And then, again, it's a current income. And so we're, again, managing in the markets and paying very special close attention to the Fed, where interest rates are going, and how to position the portfolio so that we are providing a return that is competitive and in line with the market.
KATHY: With all of the changes, you know, all the proposed changes in Fed policy—now they haven't changed policy for a while, but there's been so much talk about changing policy and so much movement in even short-term yields because of that. How are you managing around that? Does that present a particularly big challenge, or, you know, are you sufficiently liquid that you can handle it? But it just seems to me that there's a level of volatility now in short-term rates that we haven't seen in like forever. Is that providing a real big challenge right now?
LYNN: I wouldn't say it's presenting a big challenge. It is a little bit of a continuation of what we've seen for the last couple of years as the Fed has raised rates at historically a very fast pace, very quickly in a very short period of time. If you look across the universe of money market funds, one of the measures of risk—or duration, if you think about it in terms of a bond fund—is our weighted average maturity, so our days to maturity. And those have remained historically pretty short, meaning we're very defensive, very highly liquid, more liquid than ever. And in addition to really being aware of that NAV stability because of, as you mentioned, when you have some of the short-term volatility, that's where your risk would be in potentially a movement in NAVs. So you've seen a pretty big shift to most money funds across all of the sectors, historically very short. And so now, given, as you mentioned, we're still in this period of uncertainty—you know, when is the Fed going to cut rates? We aren't seeing quite as short across the spectrum as we did see over the last couple of years as the Fed was hiking rates, but still pretty short and pretty defensive until there's better clarity on where the Fed might go with the next move.
KATHY: Yeah, that makes sense. I think everybody's feeling that way right now. We're all just sort of sitting tight. Do either of you want to, or both of you, want to venture a guess as to where the fed funds rate will be at the end of 2024? It's quite the parlor game these days. I'd love to hear your thoughts.
LYNN: Um, you know, it's hard. I'd hate to, you know—the old mantra "Don't fight the Fed." So I do hate to … it seems like the market has definitely gravitated more toward just under two rate cuts projected by the end of the year. You know, we're almost mid-year now. That seems about right. So I would say probably two rate cuts by the end of the year, but again, being incredibly conservative and knowing that the Fed needs to see a lot of evidence that inflation is reliably coming down before they feel confident enough to cut rates.
KATHY: Yeah, Linda, you have the same view, or you want to be a wild card here and come up with something else?
LINDA: I'm not going to be a wild card. I do agree with Lynn, although I'm probably in the camp that I think maybe they might cut once before the end of the year. I'm not sure if I'm thinking they'll do more than that. And again, I just think that the economic figures that have been coming out, it's just been a little bit of a mixed bag that I think they're just going to be a little more patient, and I think that they're going to wait. So I think maybe one's in the cards, but I'm not sure if it's more than that. But again, it's really anybody's guess, I think.
KATHY: Yeah, I was in the three camp for a long time, then I switched to two. But it sounds like you guys are splitting the difference between one and two, which is pretty much what the market is telling you. So that's consistent with somebody who's focused on the short term and not really too worried about what's coming down the road.
So there's a whole business around the Fed's balance sheet and what's in the Reverse Repo Program and how that has been interacting with money market funds. It's a conversation that can get kind of confusing because you have many, many different sort of categories going on here and interacting. But a couple of questions I always get is "Is the Fed shrinking the balance sheet going to have an impact on, say, money market funds?" or "Are money market funds going to have an influence on what the Fed does?" Or is there something an investor should know or would like to know about this whole process?
LYNN: So the Fed balance sheet gets very complicated because there are a lot of moving parts, as you noted. So I don't anticipate any issues with the Fed reducing the balance sheet because of the fact that the Fed is cognizant of the potential risks if they were to shrink that balance sheet too quickly or too low. And those risks is where it gets a little bit complicated.
However, what they're watching is something called bank reserves. And really, bank reserves are just the amount of money that banks hold at the Federal Reserve Bank. And as the Fed reduces the balance sheet, this also decreases the level of reserves. So why do we need to know about that? It's because if that level of reserves gets too low, that's where you can have issues in the short-term markets, meaning if that level of reserve gets too low, banks are unwilling to lend money in the short term, causing volatility in short-term interest rates.
So that's what we saw in the fall of 2019, where we had a little bit of a spike in the overnight rate. It was because of the fact that reserves dropped a little bit too low. So the Fed is very aware of the fact that they need to be cognizant of where that level is so that they slow the pace of shrinking the balance sheet, which is what they announced at the last Fed meeting. So they will start to slow that.
Now, as far as the Reverse Repo Facility, it's associated, of course. However, when we think about it in terms of money funds, money funds are the biggest users of the Reverse Repo Facility. So we're always in the conversation about it.
With a little bit of background on it—the Fed launched that Reverse Repo Facility in order to provide a floor for interest rates. So instead, they have their federal funds rates target range to control the top end of the range, and the Reverse Repo Facility acts as a soft floor. So when we think about managing a money fund, we are large users of repo in general, not just the Fed's Reverse Repo Facility. And so it's working in the way the Fed intended, which is to provide a soft floor to where rates are in the economy.
So having said that, I don't think the Fed is really thinking about money funds specifically when they think about the facility. Even though we are large users, there's a lot of cash in our market and certainly, you know, with six and a half trillion dollars in assets in the money fund industry, it has the potential to influence rates in that short end. But if they want to keep a floor on it, the Reverse Repo Facility is doing a really great job and working as they intended.
KATHY: I know that that's a very complicated conversation, so thank you for walking us through it, because it does get kind of involved and people hear the story, but it's very confusing to put all the pieces together. But basically, this is all the plumbing in the financial system where the Fed wants to keep enough liquid assets available to everybody who needs them. At the same time, they don't want such a big balance sheet. They want to get down to a level that's more consistent with their long-term history. So this is going to be very interesting because I think they have to calibrate very, very carefully, particularly when they start lowering rates.
How much money do they want to leave in the system, and what are the kind of second order effects of that decline in rates as it affects what's on their balance sheet? So that should be fun to watch, at least for those of us who are involved in these markets. I think that that's going to be very important because this is about financial stability, it's about liquidity, it's about keeping the plumbing going, and nobody wants to be with bad plumbing. So this is a huge focus for the Federal Reserve and to some extent with the Treasury in terms of what they issue, etc.
So are there any changes on the horizon in the money market fund industry that people should be aware of?
LINDA: Yeah, so money fund reform is something that the money fund industry is going through right now. It's been being phased in over, really, much of this year. We have a few more implementation dates to go and it has addressed things like increasing the liquidity that's required to be maintained in the money funds. As Lynn mentioned earlier, we have to maintain at least 50% in weekly liquid assets in the funds. So that was an increase from 30%. So that's something that we've implemented.
There's been reporting requirements, enhanced reporting requirements. There are some revisions to some fees that will be implemented. That's the last leg of it that will take place in October, and so again, there are some changes going on in the industry that the funds have been implementing. And again, we should be complete and through those in October, I think is the last implementation date.
KATHY: It sounds like the average investor maybe won't notice too much about that, but they can be aware that the industry is always under pretty heavy regulation aimed at providing that safety net to make sure things stay stable.
LINDA: Yeah, the SEC heavily regulates money market funds. I think Lynn mentioned that earlier. And I think maybe it's one of the heaviest regulated sectors of the market, and it can really focus on liquidity in the funds, the stability of the net asset value, the diversification.
Money funds are very actively managed. The portfolio managers are in the market every day setting strategy, buying securities, and also making sure that we adhere to all of the regulations that the SEC has in place, again, so that these portfolios, this sector of the market, money market funds, again remain very stable investments.
KATHY: So Lynn, you're actively managing this portfolio, buying and selling these investments. How do you actually make those decisions? We know that a lot of managers of investments have their own biases, even though they say they don't, or they fight against them. You know, they chase the market, and then they overreact at times. Now, you're in very short-term investments, but how do you go about making those decisions?
LYNN: Yeah, that's a great question. And I think, you know, even in the short end, we are susceptible to that, of course, right? So one thing that I think is really, really great about our team at Schwab is that we are a team. So while we each have our sectors that we focus on, you know, we're all looking at the economy. We're all looking at the Fed. We're all looking at these broader, big picture topics that really will influence how we want to manage the portfolios. So when we think about how we want to position—like the high-level—how do we want to position the portfolios as far as our duration, you know, what sectors do we want to place, you know, investors' cash in? We're talking about it all the time, you know, between the different teams, meaning prime, munis, and in the government space. We're all having these conversations in a way that's really open, and we challenge each other, and we challenge our preconceived notions about what we might think is going to happen.
And one thing too that we talk about are "Where are our risks to our strategy? If we're wrong, what does that mean?" And so we're really cognizant, and we really think about the fact—and Linda mentioned it—that dollar in, that dollar out, NAV stability is key. And we think about that a lot as far as the risk as we invest the portfolios and where those are, where those risks lie. So that's one way we really try to avoid falling peril to those biases that we all have as human beings.
KATHY: All right, I'm going to finish up with one lightning-round question. So I asked you what you thought the fed funds rate would be at the end of the year. And I know you only focus on short-term interest rates. But if you had to guess where longer-term Treasury yields would be, say a 10-year Treasury yield by the end of the year—and I know people on trading desks are always like betting on this, right? So Lynn, what's your prediction—end of the year, 10-year Treasury yields?
LYNN: I'm going to say, I mean, we've been in a range for so long in the long-end of the market. Um, I'm going to say 4.75.
KATHY: OK, Linda?
LINDA: Ooh, I think Lynn and I are going to be fairly aligned, I think. Why don't I say—oh, I don't want to copy her answer— but why don't I say …
KATHY: Haha.
LINDA: Hold on, and I'm going to take a minute to check right now.
KATHY: You're going to take your calculator out now and …
LINDA: Yeah, I'm checking to see where we are as we speak, if that's OK. I looked this morning, but I want to see where we are now—except for I can't seem to quite get in.
I'm going to go with 4.67. How about that for really like …
KATHY: Precision, precision.
LINDA: Precision. Haha.
KATHY: I like it, I like it. But that means you're still looking at the Treasury curve being inverted by the end of the year. You're still looking at inversion. Yeah, my personal opinion is 10-year yields will be a bit lower than that, but still an inverted curve. So we'll see. Well, thank you both very much, taking time out of your busy day managing the money funds to join us. I really appreciate your insight.
LINDA: Thank you.
LYNN: Thank you for having us.
LIZ ANN: So great stuff. Money market funds super important right now, obviously in this rate environment, especially with some volatility in short-term rates. But now it's time to look ahead at next week. So Kathy, what do you think investors should be watching, and what's on your radar?
KATHY: Well, I think top of mind, top of the list, is the April PCE and core PCE numbers, since so much depends on how those numbers look. Consensus expectations are for the core rate to hold at 2.8% year-over-year. So anything that deviates from that will probably have some significant impact on the market. And I'm assuming we'll all be looking out to three or four decimal places to figure out what that number actually is.
In addition to that, we'll have the personal income and spending numbers, which are interesting, given what we're hearing from retailers about consumers starting to cut back. I think we'll have to see if that's reflected in the numbers. Would be interested in having your thoughts on that, Liz Ann.
LIZ ANN: Yeah, so the relative relationship between income and spending has not been supportive of consumption being maintained at a high pace because income gains have been coming in lower than consumption. And you're right, particularly with the retailers now in reporting season, as a reminder, they tend to report late in the season because they are one month off a calendar, a quarterly cycle. And you are seeing a lot of just shift in spending behavior and habits even up the income spectrum. So anything related to consumption and retail sales and personal consumption I think bears watching. We also get the next GDP revision which has the consumption components therein. We've got a couple of regional Fed reports, Richmond and Dallas. Chicago PMI is coming out too. We get the Conference Board's version of consumer confidence. That over the past couple of years has not shown the deterioration at lows akin to what we saw with consumer sentiment, which is another monthly reading that is in that case put out by the University of Michigan.
Just as a little bit of a backdrop as to why they will often express different things is that just based on the nature of the questions that are asked the Conference Board's consumer confidence measure tends to be biased a bit more by what's going on in the labor market, where University of Michigan's consumer sentiment tends to be biased a little bit more by what's going on in inflation. So that helps to explain. So it will be interesting to see what consumer confidence looks like, given some deterioration in the labor market. That's also why weekly claims, I think, continue to be important, not just initial claims, but the four-week average, which smooths out some of the volatility, and continuing claims, meaning folks that continue to be on unemployment insurance. And then we get a bunch of housing data next week too. And Kevin and I are going to be writing about housing, probably the next report coming out. But I think especially given the rate environment, that type of data can be a tell in terms of the economy as well.
So as always, thanks for listening. That's it for us this week, but you can always keep up with us in real time on social media. I'm @LizAnnSonders on X and LinkedIn.
KATHY: I'm @KathyJones. That's Kathy with a K on X, formerly known as Twitter, and LinkedIn. Be sure to follow us for free in your favorite podcast app. And if you've enjoyed the episode, tell a friend about the show or leave us a rating or review on Apple Podcasts.
LIZ ANN: And next week on the show, we have just such an exciting guest lined up. So Mellody Hobson. She is someone I've known for many, many years. She's the president and co-CEO of Aerial Investments, the chair of the board of Starbucks, and also the former chair of DreamWorks Animation, among many other things. And I'm really looking forward to that conversation. Always interesting with her, so stay with us for that.
KATHY: For important disclosures, see the show notes or visit schwab.com/OnInvesting.
