The US securities markets, especially the equities market, are commonly characterized as informationally efficient. This important notion of market efficiency is labeled the Efficient Market Hypothesis (EMH). (See Levy, Ch. 12, 1995.) This hypothesis has several important implications for the individual investor. One is that under-priced stocks are difficult to identify. The most often cited evidence that this is true is that professional money managers usually fail to achieve risk-adjusted returns equal to that of index funds. The most obvious implication for investors who, with reason, agree with the EMH is that they should follow a passive investment strategy that focuses on minimization of time, taxes and transaction costs. For those that don't agree, there is usually some degree of doubt about the extra expenses resulting from an active investment strategy.
The market efficiency concept should also apply to interest-rate-sensitive instruments, such as bonds and money market instruments. If the market for these instruments is informationally efficient, all existing information should already be accounted for in the price and yields of the assets, and market participants should be unable to anticipate any changes in interest rates on a predictable basis. But, contrary to the massive scrutiny afforded the capital markets by investors and academics in an attempt to support/refute the EMH, the one market that has received scant attention is the money market. For the typical individual investor, participation in the money market is epitomized by money market mutual funds (MMMFs). From an origin as recent as the early 70's, MMMFs now comprise a market of 1200 taxable and nontaxable funds that had assets of more than $1.1 trillion as of early 1998.
One of the central tenets of the EMH is competition. Yield data on MMMFs is readily available for all the world to see and may easily influence investors' selection of particular funds. MMMF managers can attempt to differentiate their yields by changing risk classes via shifting funds into usually higher yield certificates of deposit (CDs) and, especially, commercial paper (CP) and away from lower yield Treasury securities. This choice is largely guided by each fund's investment policy. However, the greatest opportunity for money fund managers to differentiate their funds' returns from others in the same risk class is to forecast short-term interest rates and alter fund maturity in response to the forecast. [Stigum, 1978]
The rationale is that MMMF managers, in the aggregate, can alter the average maturity of MMMF assets to benefit from impending interest rate changes. If rates are expected to increase, then the average maturity will be shortened so that funds' yields will increase quicker. If rates are headed down, then an increased maturity will slow the yield decline.
Investors should be curious about whether or not the MMMF average maturity index (AMI), and changes in that average maturity provide useful information in terms of impending short-term interest rate changes. Simultaneously, an analysis of the relationship between average maturity and short-term interest rates should provide additional evidence that supports or contradicts the concept of market efficiency as it applies to MMMFs.
This study examines joint questions of the usefulness of aggregate maturity MMMF data and the concept of market efficiency. Similar to Domian (1992), we utilize Granger-causality to determine if a short-term relationship exists between the AMI of the MMMF market (measured in days) and short-term interest rates (proxied by 3-month T-bill rates). In addition, cointegration analysis is used to test for a possible long-term relationship between the same variables. It is not the authors' intention to determine specifically how MMMF managers forecast the movement of interest rates, just that they may be successful in doing so. Study results would have obvious practical implications from several different aspects.
First, the analysis examines the EMH by focusing on professional money managers. Intuitively, MMMF managers are expected to outperform the market and may exhibit superior timing ability. Investors want to know if professional money managers are indeed successful in anticipating changes in short-term interest rates and are, therefore, worthy of attention. Just what is the future short-term direction of interest rates?
Second, borrowers want the same kind of guidance from the opposite perspective. Should needed loans be negotiated now, or should such an action be postponed in anticipation of declining rates? The third aspect is from the standpoint of policymakers/regulators. A primary component of current interest rates is expected inflation. Scrutiny of a changing AMI may provide evidence of interest rate expectations (including expected inflation) from a policy point of view. And, finally, financial institutions, such as banks, brokerage firms, and even MMMF managers, want to see what others are thinking. These differing perspectives comprise the clientele for the present study.
