Dry powder: what’s the big story?

There is an old saying that it is best to “keep your powder dry”. It is thought to have been said by English statesman Oliver Cromwell in the 17th century, while rallying his men as they went into battle. The powder in question was of course the gunpowder used for their muskets. The financial markets have adapted the phrase to ‘dry powder’. These days it refers to investors’ cash, waiting on the side lines, which could be invested in the markets.

Why is this phrase increasingly heard today? After the US Federal Reserve’s most aggressive interest rate hiking cycle in memory, the fed funds rate rose by over 500 basis points in the 18 months to July 2023. Investors who had previously turned their backs on cash as an asset class, during the years when returns were little better than 0%, woke up to the fact that a ‘risk free’ return of 5% in short term dollar deposits was no longer a bad option.

As the fed funds rate approached its peak of 5.25-5.50%, huge sums of cash were flowing into US money market funds. So much so that up to $6 trillion was thought to be sitting in these highly liquid funds as the year drew to a close. And when Fed chair Jay Powell announced in early December that it was “not likely it will be necessary to raise rates further”, he effectively lit the fuse under a vast arsenal of dry powder.

The potential effect of this cash being invested into financial markets has been likened to “a tidal wave of money coming”. Perhaps not so much a tsunami, but nonetheless a “slow big wave”, that could gather momentum over the course of the year. US interest rates are forecast to fall next year by as much as 150 basis points, with some expectations that the Fed will kick off a series of six cuts in the spring. Suddenly the return on cash looks relatively weaker, making other asset classes appear more attractive. 

The latest rally in equities has been driven largely by valuation expansion, meaning that earnings will need to catch up if prices are not to appear overstretched. Better corporate profitability would be helped by an economic soft landing or even no landing in 2024. As for the US Treasury bond markets, the second half of the year traditionally produces better returns, so we could see a pause in the rally as the new year starts. Although falling interest rates generally result in rising bond prices over time. Volatility might resurface next year, particularly in the light of the number of major elections, culminating with the US presidential elections in November. Nonetheless, with dry powder at current levels, markets could be well set for positive returns in 2024.