As 2014 winds down -- a big year for money market funds highlighted by the adoption of SEC MMF reforms -- JP Morgan money market strategists Alex Roever, Theresa Ho and John Iborg look ahead to 2015, "Where the Rubber Meets the Road." That's the title of the most recent commentary in which Roever and his team offer their 2015 outlook for the money market funds. "Monetary and regulatory policy will gain traction in the coming year, and the money markets figure prominently in both," writes JPM in its introduction. Among their projections, they look at interest rates, money fund flows, and supply.
On interest rates, Roever, et. al., say, "[O]ur economists currently expect that the FOMC will begin raising its Fed funds target range in June 2015, and that it will raise the target corridor twice more before the end of 2015. Mechanically, we see this as the target range rising in June to 25-50bp (from 0-25bp), with IOER going to 50bp. By the end of the year we see the target range as 75-100bp, with IOER at 100bp. In the first full year of tightening, our economists expect 150bp of tightening, based on their forecast for employment, GDP, inflation and other key economic variables. Over the course of the cycle, they expect tightening to continue until late-2017, finishing with Fed funds at 3.5%."
Next, JPM's "Outlook" looks at the potential for funds to flow out of bank deposits into MMFs. "Aside from what happens with the Fed and Treasury next year, another issue weighing on market participants is what happens to the [approx.] $10tn of deposits that are on bank balance sheets. Of concern is that a portion of these deposits could enter the money markets, further overwhelming the markets that are short on investible products.... In the coming year there are two reasons why deposits may leave banks for the money markets. The first is interest rate-driven. Over prior tightening cycles, flows into MMFs have tended to increase with Fed rate hikes, albeit on a lagged basis. In pursuit of higher returns, depositors, and mostly retail depositors, leave banks for other cash substitutes, often in the form of MMFs. When rates rise, they become more competitive relative to bank money market accounts. The second reason is regulatory-driven. Bank regulations such as LCR and SLR generally require banks to hold HQLA and leverage capital against institutional deposits, making them punitive to hold onto bank balance sheets."
How will reforms impact flows? "One important factor that is different than in the past is that structural changes to MMFs and the money markets limit the number of alternatives to which the deposits could move. This point resonates particularly with institutional shareholders. MMF reform has fundamentally altered the landscape and the appeal for the product, particularly for prime institutional MMFs. Besides the fact that most investment guidelines do not allow cash to be invested in products with floating NAVs, the inability for corporations to obtain intraday liquidity is a big issue for many institutional investors that use MMFs as a tool to manage their operational cash (anecdotally, we have heard MMFs and third party vendors are currently exploring ways to rectify this). Tack on fees/gates, which are especially troubling for sweep accounts, institutional prime MMFs are simply not as attractive as a cash management tool as before," they write.
The Outlook continues, "Government MMFs do not fare much better. While they are exempt from structural reforms, their capacity to absorb liquidity is limited by the amount of assets in which they can invest. Without an increase in government supply, a large liquidity injection would compel funds to aggressively bid for whatever paper they can find, pushing yields on bills, repo and MMF yields sharply lower.... Retail investors are less impacted by MMF reforms, but the mismatch between supply and demand in the money markets will likely keep MMF yields low for awhile, even as interest rates rise, thus lessening their appeal to yield sensitive investors."
It adds, "In the absence of MMFs, investors could choose to move beyond the money markets and into ultra-short bonds funds that operate slightly outside of 2a-7. Typically, these funds earn a slightly higher yield than MMFs as they don't have to abide strictly to 2a-7 rules. In the case of institutional investors, they could also move into separately managed liquidity portfolios, a product that asset managers are increasingly marketing as a MMF-alternative."
Will prime institutional MMF assets take a hit? "Estimates of how much money could flow out these funds have varied widely across the industry, ranging from $150bn to as much as $500bn.... Interestingly, recent data provided by ICI suggests that the actual institutional exposure in prime MMFs could actually be smaller than expected. In fact, they estimate that as of year-end 2013, roughly 34% of all prime MMF assets are owned by institutional shareholders, comprised of mostly non-financial and financial companies. The other 66% are owned by retail investors vis-a-vis retirement funds, 529 plans, retail brokers, etc. Applying these percentages to the level of prime fund assets today would imply that there are less than $500bn of assets in prime funds that are truly institutional and the other $950bn are comprised of retail money. If correct, the pool of money that's impacted by reforms could be significantly smaller than expected, biasing the amount of outflows lower. Recently, there's been discussion of potentially creating a 60d MMF as a work around to the mark-to-market issue that plagues floating NAV MMFs. However, we see two issues with this as a possible alternative. The first is there is not enough 60d supply.... The second reason is that even with a 60d maturity, the fund itself would still be a floating NAV MMF which means that the same intraday liquidity issues still apply."
Roever also looks at supply in 2015 -- the good and the bad. "While the markets have adapted to the presence of fewer investment opportunities, scarcity of assets remains a challenge in the money markets.... In 2015, there are good news and bad news. The good news is that total money market supply is poised for a rebound next year. In fact, we think total money market supply (excluding Fed ON RRP) could increase by 4% year-over-year, led by increases in Treasury outstandings. The bad news is that credit supply (total ex-Treasures) will remain flat year-over-year, driven by a confluence of factors."
What asset classes could grow next year? "Treasuries. Across asset classes, Treasury balances are poised to increase the most next year. Contrary to expectations, the rise will not necessarily come from bills as Treasury continues to extend the weighted average maturity of its debt portfolio. Instead, growth in this sector will come from Treasury FRNs and Treasury coupons that are rolling into the 2a-7 space."
It continues, "We expect balances for non-financial CP to increase gradually to $290bn by the end of 2015. Similar to prior years, very low interest rates and the sharp supply/demand imbalance in the money markets will prompt many non-financial issuers to tap the USCP market for funding, either for working capital purposes or for event-driven transactions. Indeed, since 2009 non-financial CP outstandings have grown by $176bn or 192% to $269bn as of October 2014.... We estimate outstandings of financial CP/CDs will increase 3% or $36bn year-over-year. As was the case this year, most of the growth will likely come from foreign banks."
What asset classes could shrink next year? "Repo. This is a sector that continues to encounter persistent pressures on the regulatory policy front. While changes in the regulatory environment have been evident for the past couple of years and the market as a whole has shrunk as a result, we think there is still slight room for repo balances to fall.... Taken together, we think it's possible that repo balances could fall another 2% and end the 2015 year at $2,300bn.... ABCP. This is another sector that continues to face regulatory headwinds. From LCR to SLR to the Volcker Rule to the Credit Risk Retention rule, conduit businesses have been hit from nearly every angle."
Finally, it adds, "Agencies. Our Agency strategists project agency discount note outstandings to decrease by $45bn year-over-year. As expected, a large part of the decline is going to be driven by the continued wind-down of Fannie Mae (FNMA) and Freddie Mac (FHLMC) ($35bn), particularly FHLMC ($25bn) which has been reducing the size of its retained portfolio at a much quicker pace than mandated."
