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Money Market Fund —
Money market returns hold at near-zero levels as investors await Fed action
1st Quarter, 2015
"We expect the money market curve to steepen in the third quarter of 2015 as market anticipation builds ahead of an increase in the federal funds rate. This should result in improved returns in money market funds later this year. "
– Fischer Francis Trees & Watts, Inc.

Money market investments continued to generate near-zero returns in the first quarter of 2015, as investors pondered whether economic indicators in the year ahead would reflect sufficient strength to warrant an increase in short-term interest rates by the Federal Reserve. The Fed has held its federal funds target rate at 0% to 0.25% since December 2008. The BofA Merrill Lynch US 3-Month Treasury Bill Index, a proxy for money market performance, posted returns of 0.0% for the latest quarter and 0.03% for the 12 months ended March 31, 2015.
The Harbor Money Market Fund slightly outperformed the index with returns of 0.02% for the first quarter and 0.06% for the latest 12-month period. Portfolio Manager Ken O'Donnell reports that while money market instruments traded in a narrow range in the quarter, yields on 1-year and 2-year notes rose in expectation of monetary tightening by the Federal Reserve. He believes that money market returns should improve in the second half of 2015 as the Fed moves closer to implementing an increase in the federal funds rate.
Although U.S. GDP growth decelerated in the first quarter, O'Donnell expects growth of about 3% going forward, with continued improvement in labor markets. While the economy remains vulnerable to negative influences such as declining global growth and weak inflation levels, O'Donnell believes that current levels of monetary policy should be sufficient to support U.S. growth in the near-term.
Ken O’Donnell’s comments were made in an April 15, 2015, interview. Highlights adapted from the interview appear below. All comments relate to the quarter ended March 31, 2015, unless otherwise indicated. All references to year-to-date are for the period January 1 through March 31, 2015.

Interview Highlights

Market response
As the Fed completed its bond buying program last October and began to speak of a shift towards removal of policy accommodation, the markets began to anticipate it and price it in in some form. What we’re seeing today is a fluctuating pattern as the market digests economic data that is either supportive of the removal of policy accommodation or that is showing us the opposite path, which suggests that the Fed should continue the lower-for-longer strategy. This ebbing and flowing is fairly consistent with patterns we've seen before previous tightening cycles and appears likely to persist for the rest of this year.
Improved returns
Short-term interest rates remained low in the first quarter, anchored by near-zero target federal funds rates. Both 1-year and 2-year note yields, however, have risen in expectation of a tightening of monetary policy later this year. Money market yields should follow and begin to price in the probability of a policy tightening as the year progresses. We expect the money market curve to steepen in the third quarter of 2015 as market anticipation builds ahead of an increase in the federal funds rate. This should result in improved returns in money market funds later this year.
Anticipating Fed action
We would expect one to two monetary tightenings in 2015, raising the federal funds rate to the 50 to 75 basis point range. In 2016, we’re forecasting an additional 100 to 150 basis points of tightening. The terminal rate of Fed policy is expected to be lower than in previous cycles, currently forecast to be around 3% to 3.5%. It’s difficult to have much clarity about the terminal rate at this point, but many market indicators are suggesting that it will fall into that range.
Incremental moves
Traditionally, the Fed was able to change the federal funds rate through open market transactions by adjusting the amount of excess reserves in the banking system. In the past, however, the excess reserves were roughly $1.5 billion, while today we’re at $3 trillion. As a result, the traditional mechanism would not be sufficient. Instead, the plan is to use interest on excess reserves to set a ceiling for the target rate while using the Fed's overnight fixed-rate reserve repurchase agreement program, or "reverse repo" facility, to set a floor. We believe that we’re likely to see a range, with the ceiling on the target rate initially raised from the current level of 25 basis points to 50 basis points and the floor increased to 25 basis points. It’s a different policy tool but we would expect it be implemented in 25 basis point increments, with both a ceiling and a floor.

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The views expressed herein are those of the portfolio manager at the time of the interview and may not be reflective of their current opinions or future actions.  These views are not necessarily those of the fund company and should not be construed as such.

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