At our annual Crane's Money Fund Symposium in Minneapolis in late June, we presented the views of some of the leading money market strategists in the business to get their thoughts on everything from the Fed Reverse Repo Program to fund flows; repo and T-Bill supply to interest rates. Here we report on two of those sessions. The first, "Repo Review and Money Market Observations," featured Joseph Abate from Barclays, and Lou Crandall from Wrightson ICAP. The second, "Strategists Speak: Rates and Higher Rates," included commentary from Brian Smedley of Bank of America Merrill Lynch; Michael Cloherty of RBC Capital Markets; and William Marshall of Credit Suisse. (See last week's "Crane Data News" articles below to read more coverage of Symposium, or watch for our July Money Fund Intelligence publication on Wednesday a.m. Subscribers and Attendees may also see the recordings and Powerpoints at our "Money Fund Symposium 2015 Download Center.") In the first session, Abate talked about the decline of liquidity in the market. "It's ... hard to define liquidity ... but [paraphrasing a Chief Justice on another topic], 'I know it when I see it.' How I would describe liquidity is 'You know it when it's not there.' At the end of the day liquidity is something that its absence is what defines it."
He went on to examine different parts of the market starting with Treasury bills. "This market clearly is on the downtrend at least as measured by turnover. Now that isn't to say that bills themselves are not liquid instruments, it's just that they're less liquid instruments, and there are a couple of reasons why the bill market might be perceptibly less liquid. The first has to do with dealer risk aversion. Generally for those of you who trade bills, most of you would argue that it's gotten harder to trade bills. I don't think I need to tell this audience that bills are in fact scarce and difficult to find not only are they difficult to find but expensive. Clearly there's some scarcity premium that goes into the bill market."
He also said there's been a decline in turnover in both the commercial paper and repo markets. On the repo market, he continued, "I would argue that the combination of regulatory pressure and risk aversion is most apparent in the repo market. In repo market, banks basically act as channels or conduits between money market funds and people who need to finance themselves or finance an inventory of securities. As large banks are increasingly unwilling to intermediate in this market you have a wedge that's opening up. In the repo market there's been this discussion about the fact that repo supply in a general sense isn't sufficient to meet the demand. Relatively speaking the demand for repo has gone up and the supply has gone down and the gap between the two is about $500 billion. But not only is there a gap between the supply and demand of repo, there's a wedge that prevents repo collateral from moving from those who need financing to those who are looking to provide financing." Abate concluded, "Liquidity risk is moving from the dealer to the end user -- to the person who is holding the securities. And that's a significant shift in financial markets."
Crandall also talked about a potential bill squeeze. "As things stand now it looks as if the debt ceiling will come to a head sometime in mid-November, maybe early December. Somewhere mid-to late-fourth quarter, the Treasury's probably going to face severe constraints on its borrowing. Starting in late September, we anticipate a decline of somewhere on the order of $200 to $250 billion in the supply of bills. Joe showed a chart from the Treasury about the supply of bills declining to just 11% of the total debt outstanding. If Congress takes the debt ceiling down to the wire, that's going to get down to 9% by the end of November. This would come obviously at a very difficult time for the market. We're going to be in the midst of the transition from Prime funds to 'Govie' funds, so the demand for these kinds of instruments will be very strong. Plus, we don't know when the Fed's going to raise rates, and that's a critical part of the question of what the impact of this will be. If the Fed raises rates in September, it will also increase the size of the RRP facility. But if the Fed doesn't tighten in September, the RRP facility is probably still frozen at $300 billion, and that's not going to be enough in the face of this bill squeeze. It would lead to an extremely illiquid period in the fourth quarter of this year."
On the Fed's Reverse Repo Program Abate added, "I think at liftoff the program will go unlimited -- I think maybe it'll stay unlimited at the second hike, and then very quickly a cap will be imposed. If they want the cap to be effective, it needs to be above $400 billion, given the size of the gap and given the projections for increase in demand for government assets." Crandall had a slightly different take. "I agree with that, but I'm fairly optimistic that that cap won't become binding for quite some time."
In the "Strategists Speak" session, there was also much discussion about the RRP. BofA's Smedley said, "They've [The Fed] said that quickly after liftoff they intend to minimize use of the facility. Now we think that could be measured in weeks as opposed to months after liftoff. One of the ways I think they will do that is by offering more term reverse repos. The Fed is more comfortable absorbing that cash in the term facility than they are in the overnight program."
However, Cloherty sees it differently. "I think the RRP is going to be huge and I think it's going to last a very, very long time. If the RRP is small, there's too much demand for it, and it's always overflowing, then no one can arbitrage against it. I think we're going to need a large one, unlimited or what's for all practical purposes unlimited, so it's not overflowing. I think we'll have that for many years until the Fed balance sheet runs off and shrinks to its traditional size."
He added, "The bad thing about unlimited RRP is this is a year where anything good that happens to your government funds is bad for your prime funds, because the amount of cash that stays in prime is going to be dependent on how wide the spread between Govie and Prime funds is. The trouble is that none of us have any clue how much cash is going leave [Prime funds]. The statistical model I use is the 'wild guess'. I can give you a number but the number is going to be plus or minus $400 billion, so it's completely useless," he joked. "If you're a prime fund, you're going to have to set up for the worst case possible outflow. You're going to have to get ludicrously short."
On the RRP, Marshall said, "I think I'd probably fall somewhere in between my two colleagues up here in terms of how permanent and how large the facility will be. In my view it is likely to be significantly larger, and I think that it will be somewhat longer lasting in nature." He added that the amount of inflows into Government funds will depend on the spread between Government and Prime funds. "Hopefully that will be somewhat clearer by the time we get to next October, and hopefully we'll have a Fed that's well into a hiking cycle." Finally, Marshall showed a slide that showed how money market fund assets ballooned during past Fed rate hike cycle, with about an 18-month lag. Given that history and the regulatory pressure that banks are under, money funds could start to see asset gains once the hike cycle matures, he said.
