US money market funds have notably shortened the duration of their holdings since mid-May. Data from Crane Data LLC indicates the weighted average maturity of these funds' holdings has decreased from 45 days to 40 days, reflecting that fund managers are reducing exposure to assets with even slight interest rate risk and shifting more capital into ultra-short-term instruments.

In terms of specific allocations, managers have increased investments in overnight repurchase agreements and short-term securities while boosting their holdings of floating-rate agency debt and floating-rate US Treasury securities. Despite the government's continued ramp-up in Treasury bill issuance, money market funds' exposure to T-bills saw a slight decline.

This adjustment comes against a backdrop of heightened uncertainty regarding the Federal Reserve's policy path and the near-term interest rate outlook. A surge in international oil prices, coupled with hawkish commentary from Fed officials, initially prompted traders to price in the possibility of a rate hike as early as this month. However, two moderate inflation reports last week have muddied the policy waters, leading the market to reassess related bets.

In this environment, money market funds managing over $8 trillion are favoring securities that mature within weeks or feature rates that can be rolled over or reset. This approach preserves the flexibility to reinvest at potentially higher yields if rates move upward again. Deborah Cunningham, Chief Investment Officer for Global Liquidity Markets at Federated Hermes, stated, "You need to preserve ample liquidity to take advantage of better investment opportunities ahead, so you want those weighted average maturities to be a little bit shorter."

Fund managers' caution regarding interest rate risk is also informed by the experience of early 2022. Just before the Fed embarked on one of its most aggressive tightening cycles in decades, some managers were caught off guard by holding longer-duration assets. This experience makes them more reluctant to extend duration when the policy outlook is unclear.

Looking at fund flows, repurchase agreements remain a core destination. Geoff Gibbs, Managing Director at DWS Group, noted at a Crane money fund symposium last month that they have kept roughly half their portfolio allocated to repos for most of the year and do not expect that to change, especially with rate hike expectations now baked into the outlook. Crane Data shows money market funds increased their repo allocations by approximately $36 billion in June, bringing the total to around $1.89 trillion.

The appeal of floating-rate notes is also rising. According to Wells Fargo strategists Angelo Manolatos and Francis Brown, funds have further increased their holdings of these assets. In June, money market fund holdings of US Treasury Floating Rate Notes (FRNs) climbed to a record $523 billion. This indicates managers are seeking to capture the elevated yields on three-month T-bills while avoiding extending duration.

Increased supply in the agency debt market aligns with these allocation shifts. Data from the Federal Home Loan Banks' (FHLB) Office of Finance shows FHLB's outstanding debt has risen by about $180 billion this year, with approximately $140 billion of that in floating-rate notes. Over the same period, money market funds' overall agency debt holdings increased by roughly $195 billion.

In contrast, US Treasury bills, despite their continued expansion in supply, have not seen a corresponding increase in allocation. Money market funds' T-bill holdings actually decreased by nearly $105 billion last month.

Regarding future trends, several industry insiders anticipate further duration shortening. Cunningham expects the weighted average maturity to continue declining as the Fed prioritizes bringing inflation back to its target.

Manolatos added, "Given the possibility of a September rate hike remains on the table and there is a lot of hawkish Fed rhetoric about potential hikes, money market funds will want to start shortening their weighted average maturities from here. For fund managers, the bar to do anything other than put excess cash into repos or floating-rate notes is quite high unless they absolutely have to."