Will the expected migration of assets from Prime to Government money market funds be thwarted by the availability of supply? Fidelity Investments, which will convert three Prime Retail funds to Government MMFs (see our Feb. 2 "News") including the $110 billion Fidelity Cash Reserves, says the market has more than enough capacity to handle the inflows. They recently published a paper entitled, "Government Money Market Mutual Funds: An Attractive Option for Investors, which explains that the sector is poised for growth given the SEC's 2014 money market reforms and can handle any inflows. However, in his most recent "Short-Term Market Outlook and Strategy," J.P. Morgan Securities money market strategist Alex Roever and his team see it differently.
Fidelity estimates the size of the "Short-Term Government Bond Universe" at about $6.6 trillion. Of that $6.6 trillion, $1.5 trillion is in Treasury Bills, $1.6 trillion is in Treasury Coupons, and $164 billion is in Treasury Floating Rate Notes. This totals roughly $3.3 trillion within the money fund-eligible Treasury space. Fidelity also cites the size of the Repo market at $2.0 trillion, and the Reverse Repo at $397 billion. Another $602 billion in in Agency Discount Notes, plus $357 billion in in Agency Coupons ($959B in total Agencies).
Crane Data shows Treasury Institutional MMFs totaling $349 billion, Government Inst MMFs totaling $331 billion, and Treasury and Retail MMFs (combined) totaling a $256 billion So the total of the Govt and Treasury MMF sector is currently $913 billion. The paper explains, "The depth and breadth of the $6.6 trillion short-term government securities market provides a liquid investment universe for government MMFs. Within this high-quality sector, government MMF investments represented approximately 14% of the assets at the end of 2014."
Fidelity concludes, "The 2014 money market reform rules may increase the demand for government MMFs, which could also increase the demand for government securities. If this is the case, it is possible that the yield spread between prime MMFs and government MMFs may increase. However, it is unlikely to change the value proposition that government MMFs will offer."
Speaking earlier this year, Fidelity's President of Fixed Income Nancy Prior (see our March 13 News," explained, "The government securities market is enormous, at close to $7T. So each $100B in incremental demand represents just 1.5% of the available supply. While we do not know other firms' plans, let's just use Moody's estimate of an additional $100-$200 billion of assets' converting to government from prime, which may end up being high. Taking the middle of that range -- $150 billion -- and adding that to Fidelity's proposed conversions gets Moody's total estimate to $280 billion. That additional $280 billion in demand represents only about 4% of the total supply of government securities. So, standing where we stand right now, we believe that the converted MMF assets within the industry will have no trouble finding investments in the government market.... There continues to be adequate supply for prime MMFs."
But JPM's Roever, and co-authors Teresa Ho and John Iborg, believe that supply in the government space will be an issue if demand for government MMFs spikes as anticipated. They write in a section entitled, "Government MMFs: Demand growth in a world of limited supply," "In previous notes, we've discussed how money market reform and regulatory induced deposit shedding by large banks is likely to push a large amount of cash towards the government money fund space over the 12 to 18 months. We have argued that demand for government funds could rise by $700-900bn before the end of 2016. Such a large shift of cash will most certainly complicate the market structure for short-term government and agency securities, where front-end demand has remained strong and supply constrained for quite some time."
Roever and Co. explain, "To start, we performed a high level analysis to see how demand might increase across asset type under different government MMF inflow scenarios, holding current portfolio allocation percentages constant. Not surprisingly, our results project stark implied increases in demand across Treasuries, agencies and repo. However, it is unlikely that these increases will be met by equal increases in supply. While it is unclear how outstandings will change across asset classes from now until the end of 2016, we expect that the supply in the short-term government and agency markets (ex Fed RRP) will decline."
They continue, "Given that supply will not grow in tandem with demand, we think that government MMF complexes will have three options to weigh as they face large inflows. First, government funds may decide simply not to take in extra cash once marginal investible supply is no longer available. This situation occurred for several funds during 2011, when the Eurozone crisis prompted a large flight to quality of close to $200bn into government MMFs. Obviously, government funds closing to new money would be bad news for investors, as few alternatives would be available for them to put their cash. Investors could look beyond the money markets in this case, but options that meet their specific liquidity needs may be scarce."
JPM's piece tells us, "Secondly, to ensure that they get invested, government funds will have to bid more aggressively for the available float of product that is already outstanding, effectively becoming larger owners of the total market. Needless to say, this will exert an immense downward pressure on yields, especially in the shrinking product sectors, as government funds are already significant players across markets. During the 2011 episode, government funds turned first to bills and Treasury repo to meet their supply needs, before steadily increasing their participation within Treasury coupons and agency discos. On net, government funds increased their market share by an average of 5% across these products."
Further, they write, "Lastly and unlike 2011, many government funds will have the option of using the Fed's reverse repo program. Government funds that are RRP counterparties currently have about 27% of their assets invested at the facility. Furthermore, with the Fed likely to begin raising interest rates at the same time large inflows occur, it is likely that the rate on the RRP will be higher than other government asset types -- making it a more attractive choice for eligible counterparties. The remaining money funds and other front-end participants who are not RRP counterparties, are indirectly dependent on the size of the fed RRP -- the more RRP that is available for the counterparties should result in more supply and higher yields for the non-counterparties as well, although likely yields below the RRP level."
J.P. Morgan adds, "All told, we do not believe that there will be an ample amount of supply of bills and similar instruments available to meet demand in the short-term government/agency space once sizable inflows into government MMFs begin. In a best case scenario, the Fed would raise the usage cap on the RRP so that it could further serve as a source of supply to MMFs who are counterparties and hopefully leave more government securities available for the non-counterparties."
Finally, as we approach October 2016, market participants will continue to monitor and predict potential inflows into government money market funds, and potential shifts in Government supply. Barclays money market strategist Joseph Abate said he expects the Fed to temporarily remove the cap on the overnight RRP at rate life-off this fall. "This could easily fulfill any increased repo and bill demand caused by money funds reform," he writes. (Watch for the Treasury's Quarterly Refunding Statement Wed. a.m., and their Quarterly Refuning Press Briefing for some clues as to the future level of Treasury bill supplies.)
