JP Morgan Securities US Fixed Income Strategy team released its weekly "Short Term Market Outlook and Strategy" report, which examines the impacts that S&P's ratings reviews of banks could have on money markets, particularly, widening the gap between supply and demand. JP Morgan strategists Alex Roever, Teresa Ho, and John Iborg also look at money market holdings for May, which showed a drop in Treasuries and an increase in Reverse Repo Program usage. On the S&P ratings they write, "Not to be outdone by Moody's, this past Tuesday S&P also concluded its reviews on various global banks and banking groups domiciled in the UK, Germany, Austria, and Switzerland. The reviews were initiated in February as part of its efforts to reflect new resolution regimes put in place in these countries."

It explains, "Rating actions were taken based on S&P's assessment of the amount of extraordinary government support regulators would provide and the amount of bail-in capital banks currently hold or expected to hold. To be sure, not every bank was downgraded as part of the review. Some were affirmed at the current level with a stable outlook in spite of their being on negative watch/outlook previously (e.g., HSBC, CS (Credit Suisse), UBS). Others were affirmed at the current level with a negative outlook (e.g., Santander UK). One was upgraded at the holding company (e.g., Lloyds). Still, there were a handful of banks that were downgraded, including BCLY (Barclays) and DB (Deutsche Bank). In particular, they were downgraded at the operating company level to A-/A-2 and BBB+/A-2 respectively, effectively becoming Tier 2 issuers in the money markets."

They add, "For investors, the step into Tier 2 territory for BCLY and DB matters a great deal. This is true particularly for S&P AAA-rated MMFs whose investment guidelines prohibit them from investing in securities that have a short-term rating of A-2 and below. This would apply to CP, CCP, ABCP, as well as traditional and non-traditional repo. To the extent that they want to engage in trades with an A-2 counterparty, those would be considered "higher-risk investments" which would then put the funds to be BB-rated. As of May month-end, we estimate there were $22bn of exposures to BCLY and DB in S&P rated MMFs, most of which is in repo but all of which would need to be divested in order for the funds to maintain their AAA rating."

JPM explains, "All told, the bank rating downgrades are yet another force that is widening the supply and demand gap in the money markets. Not only are banks issuing less short-term funding due to a variety of regulations, but rating agencies are also shrinking the pool of investible supply in which rated MMFs could invest. In the meantime, the demand for short-term high quality assets continues to grow via money fund reform and banks shedding non-operational deposits, creating capacity issues for MMFs. Anecdotally, we have heard that some MMFs are actively considering removing their S&P rating, perhaps as a way to enlarge their pool of investible supply. Currently, S&P rates about 75% and 45% of the assets under management in government and prime MMFs respectively."

They continue, "From a markets perspective, fund managers will need to find alternatives to replace the investments affected. Based on data this past week, it appears some of it went into the Fed's ON RRP facility as balances grew by $14bn two days following the S&P downgrade, reversing a steady decline that was taking place the prior two weeks. To a lesser extent, we suspect some of it was also replaced with higher-rated counterparties in the repo space, though it's unclear how much additional capacity other dealers absorbed given balance sheet constraints in the overall marketplace. Over the past three years, there has been more shrinkage than growth among dealers in tri-party repo balances with MMFs."

Also, they say, "It is worth noting that given recent bank rating changes at S&P and Moody's, DB is now officially a Tier 2 issuer rated A-2/P-2. BCLY is a split Tier 1 issuer rated A-2/P-1. Even outside of MMFs, most money market investors would likely be averse to investing with DB and to a lesser extent BCLY due to their non-Tier 1 counterparty ratings. Assuming the size of their balance sheets remains unchanged, we suspect the banks will likely rely more on the GCF interdealer repo market for funding, which could bias GCF repo rates higher. That said, given all the focus to shrink balance sheets in light of the high cost of capital, it's unclear how much of the $22bn will actually be moved into the GCF repo market."

In their holdings update, Roever et al write, "Prime MMF assets under management increased by $27bn or 2% during May, recouping a portion of the outflows experienced during tax season and YTD. Prime institutional funds received the majority of inflows with +$25bn, while prime retail funds increased modestly by $2bn. At the end of the month, prime fund assets totaled $1,408bn. Furthermore, government MMFs witnessed a modest $4bn or +0.5% in inflows, and currently stand at $933bn. Most sector allocations remained relatively stable over the course of the month."

JPM explains, Holdings of US Treasuries decreased by $12bn while RRP usage increased by $12bn. While Treasury holdings did drop during May, we suspect that prime fund buying of UST will pick up going into quarter-end. Furthermore, we look for prime funds to become increasingly larger buyers of short-term Treasuries in the months to come as money market fund reform pushes funds to build liquidity. In total, prime funds increased their exposure to bank paper by $18bn month-over-month. CD and time deposit balances were responsible for the increase, going up by $18bn and $19bn respectively mostly across European issuers. Conversely, holdings of dealer repo decreased by $10bn."

They write, "Funds continued to focus on keeping short maturity profiles during May. WAMs and WALs remained near multi-year low levels and finished May at 37 and 64 days respectively. We attribute this enduring maturity-shortening trend to two main drivers: 1) Federal Reserve rate hike expectations and 2) liquidity building meant to meet potential redemptions stemming from seasonal factors and money market fund reform. Notably, throughout the month we noticed a sustained focus on positioning around the September FOMC meeting, with investors preferring fixed product maturing before 9/17 and floaters spanning over 9/17. Furthermore, we have anecdotally heard that investors are beginning to factor in money fund reform while making decisions on longer dated paper."

JPM adds, "Money market funds bought $1.9bn in Treasury floaters during May. MMFs now own $53bn, or 23% of the 2-year Treasury FRN market. Treasury funds have been the largest buyers of Treasury floaters to date, and hold $36bn, while government agency funds hold $2bn and prime funds hold $15bn. Total usage of the Fed RRP at the end of May registered $160bn. Of this amount, MMFs accounted for $138bn in usage or 86%. Prime MMFs took down $36bn of RRP while government funds took down $102bn."

Finally, they tell us, "For the end of Q2, the Fed further indicated that it plans to offer at least $200bn in two term RRP operations to supplement its overnight facility, whose current cap is set at $300bn. The operations will take place on June 25th and 29th, and their respective size and offering rates will be announced later this month. On balance, we think that the continuation of term RRP offerings around quarter-ends is beneficial for the money markets. During the two quarter-ends where the term facility has been offered by the Fed, it has proved to be a viable source of backstop supply to money market funds while also providing them an option to get cash invested earlier. Hence, we anticipate the term operations to draw healthy demand, especially from government funds."

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