Liquid funds are mutual funds that invest primarily in money market instruments such as treasury bills, commercial papers, and certificates of deposit. These funds are popular among investors wishing to lodge extra funds for brief periods of time due to their low risk profile and high liquidity. Nonetheless, the performance of liquid funds can be strongly influenced by central bank monetary policy decisions. Read on to learn how.
What is a monetary policy?
Monetary policy refers to a central bank’s operations to regulate the money supply and achieve economic goals such as price stability, inflation control, and economic growth. To impact the economy, central banks utilise a variety of measures such as interest rate adjustments, open market operations, and reserve requirements. Below are a few ways change in monetary policy or interest rate changes affect liquid funds.
Changes in interest rates
When the central bank raises interest rates, it makes borrowing money more expensive for businesses and individuals. This might lead to a drop in demand for money market instruments and, as a result, a drop in their yields. As a result, liquid funds that predominantly invest in these products may underperform.
In response to growing inflation, the Reserve Bank of India (RBI) hiked interest rates multiple times in 2018. This resulted in lower yields on money market instruments and, as a result, lower performance of liquid funds that invest in these securities.
As the central bank reduces interest rates, it becomes less expensive for businesses and individuals to borrow money. This can result in increased demand for money market instruments and, as a result, higher yields. As a result, liquid funds that invest in these products may perform better.
For example, in reaction to the economic impact of the COVID-19 epidemic, the RBI cut interest rates in 2020. This increased the yields on money market instruments and, as a result, improved the performance of liquid funds that invest in these securities.
Monetary policy changes
Monetary policy also influences liquid funds part of mutual funds performance through changes in liquidity in the money markets. When the central bank injects liquidity into the money markets via open market operations or other means, it can enhance the availability of money market instruments and, as a result, lower their returns. This can cause liquid funds that invest in these instruments to underperform. In 2019, for example, the RBI injected liquidity into the money markets using a variety of techniques such as open market operations and FX swaps. This resulted in lower yields on money market instruments and, as a result, lower performance of liquid funds that invest in these securities.
Conclusion
Central bank monetary policy actions can have a significant impact on the performance of liquid funds. Changes in interest rates and liquidity in the money markets are just two of the factors that can impact the performance of these products. While it is hard to forecast when or how monetary policy choices will be made, investors can reduce their risk by diversifying their portfolio by investing in a mix of stock, fixed-income, and alternative assets. Working with a financial advisor can also assist investors to navigate the market’s ups and downs and make smart investing selections.