Back in 2017, local government investment pool (LGIP) participants were excited and ready to take advantage of the first rising interest rate environment in nearly a decade. While the Fed raised rates once in December of 2015 and again in December of 2016, they began rapidly raising historically low interest rates at the start of 2017; by the end of 2018, the Fed had raised rates a total of nine times, making short-term investors happy with materially higher yields on their investments. Unfortunately, the Fed reversed course in the second half of 2019 and in March of 2020 when the Federal Open Market Committee (FOMC) dropped rates by 150 basis points at the start of the COVID-19 pandemic. This effectively kept short-term rates near zero ever since in response to the resulting economic downturn.
But as the economy continues to show signs of recovery and the Fed adopts a more hawkish tone, LGIP participants are now well-positioned to take advantage of rising rates once again. Given the short average maturity of pool investments, LGIP yields can adjust rapidly and provide a current market rate. As holdings in an LGIP mature, fund management invests these proceeds into high yielding securities thus providing investors with a more current (and higher) market rate. Many LGIPs performed very well during the last rising rate environment, closely mirroring the current Fed Funds Rate at that time and well above bank deposit rates.
One reference rate that investors use to determine how LGIP yields will behave is the Fed Funds Rate; this is the interest rate at which banks and other depository institutions lend money to each other, usually on an overnight basis. It is an excellent benchmark for short-term interest rates. Unlike bank deposit products, stable net asset value LGIPs quickly adjust to upward movements in market interest rates. The chart below shows the growth of the Fed Funds Rate during the last rising rate environment when the Fed Funds Rate moved from approximately 0.50% to almost 2.50% over the course of two years. Conversely, various bank deposit rates only moved from about 0.00% to approximately 0.25% over the same period.
For the first time since 2018, the FOMC voted to raise the Fed Funds Target Rate by 25 basis points to a new range of 0.25% to 0.50% and indicated the potential for six additional rate increases by the end of the year at their meeting on March 16, 2022. While the labor market is close to full employment, inflation is at a 40-year high and still accelerating. Despite the current geopolitical risks, the FOMC needs to re-establish its inflation-fighting credibility.
Now is a great time to start the discussion with decision makers at your local government about investing in an LGIP so your entity can take advantage of the current rising rate environment.
For more information on how to best navigate your entity’s portfolio in a rising interest rate environment, please contact the NYCLASS Relationship Team!