Returns on US money market funds are still slim by historical standards, but as interest rates rise, investors' interest in these funds could grow, possibly supporting the dollar. Over the last year, faced with paltry US money market rates, a declining dollar and uncertainty about the performance of US stocks and bonds, US retail investors have shown more interest in foreign assets. Retail online trading platforms have noted a surge in demand for foreign currency while deposit accounts in other currencies have also sparked interest.
"We had never gotten requests for foreign currency money market funds until the end of 2004 and early 2005," notably in sterling and euros, said Peter Crane, managing editor of Money Fund Report, a weekly newsletter in Westborough, Mass.
US investors, "starved for returns", have hunted for higher-yielding foreign assets, he said.
Treasury Department asset flow data show US investors stepped up buying of foreign equities in recent months. If that trend accelerates it could weigh on the dollar, currency analysts warn.
Yet the Fed's interest rate hiking cycle is helping attract yield-seeking investors back into US assets, as the European Central Bank keeps its key interest rate unchanged at 2 percent, while Japan's rate remains effectively zero.
US cash and money market funds may be a good place to be as the Fed continues to hike rates, said David Kotok, chief investment officer with money management firm Cumberland Advisors in Vineland, New Jersey.
He expects the key federal funds rate to rise to about 4.5 percent within a year from 2.75 percent now.
Some analysts cite an incipient reversal of flows back into dollar-denominated money market funds.
"It is already occurring, as returns in other markets lag and even come down a little bit. It is just a matter of time before cash starts moving into US dollar cash and money market funds," said Crane.
US taxable money fund yields are now at around 2.11 percent, up from a record low of 0.5 percent in August 2003.
By year-end these rates could reach 3.5 percent, says Crane. "As we break (above) three percent we expect the interest (of investors) to increase markedly," he said.
The dollar would be most likely to benefit from a resurgence of interest in US money market funds if risk aversion rises, especially if world equity and bond markets were to falter simultaneously.
"In a climate of global risk aversion, the tendency of investors is to run to money markets in their own currencies, unless the source of the risk is local," said one US-based hedge fund analyst.
In such a scenario, as one of the major economies with increasingly high cash and money market rates, the United States could retain more investments in these dollar-denominated instruments and even tap more inflows from abroad, the analyst said.
A disappointing year or so ahead for US bond prices that some fixed-income strategists foresee could also fuel US investors' demand for cash and money funds at home.
In mid-2006, the Federal Reserve's monetary tightening cycle could reach a peak and yields on the benchmark 10-year US Treasury bond could rise to between about 5.25 percent and 5.50 percent, up from about 4.52 percent on Friday, said Jack Malvey, chief global fixed-income strategist with Lehman Brothers in New York.
Until then, "bond returns may not be as generous: you may see 12 months of negative total returns," Malvey said.
Yet about the time that bond yields start to peak and investors start to view bond markets more favourably, "once we are done with the Fed moving (rates) up and we see a bit of risk in the system, then I think you will start to see more positive money market flows," Malvey said. However, the substantial volume of flows among global bond and stock markets will be more likely to set the dollar's tone than will US money markets flows, Malvey added.