In his latest "Money Markets Monthly Update," Barclays Joseph Abate comments on the "future of repo" and examines the moves that money market fund complexes have made to date in response to the SEC's money market fund reform. Also, Citi Research Strategist Vikram Rai talks about how too much cash chasing too few assets in the short duration space has reached a tipping point and he analyzes the impacts of BlackRock's recently announced MMF changes.
On the future of repo, Abate writes, "Regulators hope to see a smaller, less systemically risky repo market emerge in the coming year. But it is not clear whether they have a specific size "target" in mind." What happens next? Abate writes, "We expect repo activity to decline as banks adapt to a new world of leverage limits, net stable funding, and liquidity requirements. Repo volumes could fall by an additional 20% from here. The timing of the adjustment is unclear. Regionally, banks are at different stages in the adjustment process. A smaller repo market in which balance sheet reporting dates are less significant (because of daily averaging) might be less volatile and more predictable."
He also discussed rising demand created by "money fund reform and a conversion of (some) prime funds to government-only. Government only funds invest 35% of their balances in repo, and there is $1.4trn in prime funds potentially facing either floating NAVs or liquidity fees and redemption gates." Also, he adds, "Large banks may decide to push non-operating deposits off their balance sheet, given deposit insurance and balance sheet costs. How quickly will banks raise their deposit rates once the Fed lifts off? Lingering secular bill supply scarcity might push more investors toward repo, especially if investor demand for government-only funds rises."
On money market reforms, Abate looks at the range of strategies that have been announced by money fund complexes thus far. "Managers responsible for roughly 40% of prime institutional fund balances have already announced their post-reform plans," he writes. They have announced a variety of strategies, which Abate enumerated: "1. Consolidate funds with similar investment objectives; 2. convert prime institutional funds to government-only funds; 3. Shorten the maximum maturity of prime funds to less than 60d; 4. Do nothing -- let the (institutional prime) NAV float and adopt fees and gates; 5. Establish separate accounts for some large cash investors."
Of what has been announced so far in the $1 trillion Institutional Prime space, $262 billion will float the NAV, with gates and fees. In addition, $2.5 billion will float the NAV with maximum maturities of 7 days or less, while an undetermined amount of assets will float the NAV with maturities of 60 days or less. Also, $130 billion will convert to government funds. He writes, "Prime institutional funds adopting the govt-only change of status strategy could significantly change interest rate dynamics in the front-end by boosting the demand for bills and repo, which are already in short supply, and reducing the demand for short-term bank paper like CP, AB-CP and time deposits. Banks -- particularly non-US institutions -- may need to replace their short-term unsecured funding and pay higher rates. All things equal, we expect this shift -- depending on how widely adopted by prime institutional money funds -- will widen LOIS, pushing bill and repo rates lower and Libor potentially higher. So far, however, most funds appear to be avoiding this post-reform strategy."
Strategist Vikram Rai from Citi Research issued his latest commentary, "Are We Moving Closer to Benchmark Tipping?" He writes, "`While too much cash chasing too few assets is a phenomenon which is plaguing the entire fixed income industry, in the short duration space, this crisis has reached, well, a tipping point, in our view. The supply of investable short-term paper has mostly declined since 2004 (we estimate that total investible supply is down by about $1.2 TR since late 2010) though the demand has increased dramatically given the surfeit of cash which needs to be invested in short-term assets only due to the regulatory changes affecting banks (LCR, SLR, NSFR etc.). Economic theory teaches us that supply will (typically) meet demand but this is unlikely to be true for T-bills where growing demand is expected to far outstrip supply, which could remain static or even shrink."
He continues, "A paper on "benchmark tipping" (authored by Robert McCauley, BIS, March 2001) discusses the development where private instruments eclipsed government paper as a benchmark. Specifically, in the 1980s, trading volumes in Eurodollar futures contracts (introduced in 1982) surpassed trading in T-bill contracts. The catalyst for this development was a series of traumatic episodes in which either a flight to safety bid or a supply demand imbalance caused a rapid widening of the TED spread. This acted as a double edged sword for investors with positions in short term credit instruments that were hedged with T-bills. So what is the common thread between the developments in the money markets of the 1980s vs. money markets today? The common thread appears to be trauma. The trauma of having to invest in govt. paper with yields, which if not negative, are far less than comparable maturity high grade credit instruments and also the trauma of having to deal with divergent benchmarks. Front end rates are likely to exhibit divergent behavior and the short-term Treasury yields could breach the O/N RRP floor." Rai expects that investors will respond to the supply demand challenge by searching for investment alternatives, citing separate accounts, ultrashort and short duration funds, hybrid products which emulate CNAV and FNAV funds, and private money funds.
Rai also talked about BlackRock's recent MMF lineup changes, which we reported in our April 7 News, "BlackRock Announces Changes, Keeps Options Open; TempFund Floats." He writes, "BlackRock's steps are pragmatic though slightly different from the steps taken by other industry leaders in this space...." Rai says these steps should result in a number of impacts, including wider front end spreads. "The conversion of its prime retail funds to CNAV/govt. funds is in line with the steps taken by Fidelity and the implementation of this step should impart further downward pressure on T-bill, TSY repo and Fed fund rates. And, assuming that these proposals are implemented, the demand for govt. securities will come at the expense of credit products like CP, ABCP, and other short-term bank obligations, which will lead to wider CP-T-bill spreads, Libor-OIS spreads etc."
Another impact is, "Marginally steeper money market curves: The decision to offer institutional prime funds with a lower WAM appears motivated by the ability for these funds to evaluate their securities using amortized value. And, by limiting maturities to inside of 7 days, the resulting fund NAV is unlikely to exhibit much volatility. Federated has employed a similar change to its strategy though it stated that some of their institutional prime and municipal money market funds will limit their investments to securities maturing in 60 days or less. The move to limit WAM to less than 60 days is unlikely to steepen the 1m3m curve or the 2m3m curve despite the fact that issuance in the 30-60d sector has been dwindling as banks are trying to extend their short term financings to beyond 3 months. This is because a very large percentage of MMFs (we estimate about 75% by AUM) have WAM inside of 60 days. BlackRock's WAM limit of 7 days does seem a little more drastic but in our view, we could see increased issuance in shorter maturity sectors as issuers tap into the increased demand for higher grade, shorter maturity paper which could mute the steepening of the money market curve."
Finally, Rai writes, "Counterbalance institutional prime fund outflows: We strongly agree with BlackRock's attempt to provide intra-day liquidity to its institutional prime fund clients through at least three NAV calculations a day, with a morning, mid-day and afternoon fund wire. This could serve to counter balance to the potential immediate reaction among clients who will be forced to switch to FNAV funds and thus stanch outflows from institutional prime funds."
