Variables Affecting Performance of Money Markets
Monetary Policy is managed by the Federal Reserve Board (the "Fed") and has a direct impact on short-term interest rates. If the Fed determines that inflation is climbing, it will enact a policy to decrease or "tighten" the money supply. With less money available, money lenders can command higher interest rates on the money market securities they sell. On the other hand, if the Fed determines the economy is heading toward a recession, it will increase or "ease" the money supply. With more money for borrowers to access, the interest rates for money market securities decline.
Interest Rates will affect money market yields because as investments mature, the cash received will be reinvested at current money market rates which could be either higher or lower. Reinvesting at higher interest rates generally means higher yields for money funds and reinvesting a lower rates generally means lower yields.
Average Length of Maturity
Average Length of Maturity affects the timing of reinvesting cash from maturing investments. If interest rates are expected to rise, decreasing the portfolio's average length of maturity would enable an investor to purchase higher-yielding money market securities sooner. Conversely, if rates were expected to decrease, an investor would invest in money market securities with a longer length of maturity in order to maintain higher yields longer.
Terms to Know
Yield is the amount of net investment income (income minus expenses including management fees) your investment has produced over a specific period, expressed as a percentage of your investmnet. Capital gains and losses, which are infrequent in money market investments, are not included.
Maturity is the time remaining before an issuer is scheduled to repay the principal amount on a debt security. Money market instruments are debt securities.
Yields tend to vary directly with a security's length of time to maturity. The longer the maturity, the higher the risk that interest rates could change, which is why investors are typically rewarded with a higher yield. For example, the yield on a 1-month Treasury bill is typically lower than the yield on a 1-year Treasury note. When the relationship between yield and maturity is plotted on a graph it is called the yield curve. If yields for long-term investments drop, the yield curve will "flatten" since there will be less of a difference in yield between shorter-term and longer-term investments. When this happens, it also means longer-term securities are relatively less attractive. When long-term yields increase and the curve steepens, longer-term securities become relatively more desirable.