At last week's 6th annual Crane's Money Fund University in Boston, the state of money market supply was a theme woven through several of the sessions. While the industry has been dealing with a supply-demand imbalance in recent years, the outlook for supply in 2016 is optimistic, according to the experts. Barclays' Director of Fixed Income Strategy Joseph Abate and J.P. Morgan Securities' Executive Director `Teresa Ho shared their perspectives on why in two separate sessions. We also heard from portfolio managers, including SSgA's Todd Bean, who talked about the fundamental objectives of cash management. For a broad overview of MFU, see our Jan. 25 News, "American Beacon Goes Govt; Crane's Money Fund University Sets Record," and visit our "Content Center" and our "Crane's Money Fund University 2016 Downloads" page to access the MFU Binder and Powerpoints (available to attendees and Crane subscribers only).
In the session, "The Federal Reserve and Money Markets," Barclays' Abate examined the supply demand imbalance and offered his optimistic outlook for 2016. He says, "If you look back before the financial market crisis you could make the argument that there was a shortage of government safe assets. Historically, government safe assets as a share of total assets has been about one in three. Beginning in the mid-90s and certainly accelerating around 2000, the share of government safe assets began to fall. `So, banks decided that there was a market here to create money-like substitutes for T-bills, including ABCP ... and all sorts of other maturity transformation tools that effectively mimicked government safe assets."
He adds, "They were highly liquid, they had supposedly deep markets, and could be changed into cash quickly. But the financial market crisis in 2008 demonstrated that without government backing, what looks like a government safe asset is in fact not a government safe asset. That partly explains why markets like repo and in particular CP have detracted sharply. The asset backed commercial CP market was at one point over $1 trillion, now it is considerably smaller than that -- somewhere around $300 billion."
Abate continues, "The Bill universe has shrunk considerably since 2009, and there are essentially two reasons for this. The first is the budget deficit has continued to come in smaller than expected.... The other thing that's happened is the Treasury, to reduce rollover risk, has lengthened the average maturity for debt outstanding. So, as a share of total debt outstanding, Bills have contracted from around 20% to around 11%. And before the debt ceiling was resolved, the universe contracted to about 9.9%. If you go back to 1952, we've never seen the Bill universe as small as it is today. Now, obviously, in absolute terms, at $1.5 trillion, it's still quite large, but absolute vs. relative are two very different stories."
Looking ahead to 2016, Abate says, "My sense is that the supply pressure for you guys in terms of looking for the safe assets is going to abate in the coming years. I think Bill issuance could increase by $125 billion this year, but it could be significantly larger than that." Abate says it could be as much as $250 billion, or higher. He adds, "Secondly, the Fed's Reverse Repo Program, at $2 trillion, for all intents and purposes, is unlimited." He continues, "If the supply of Treasury bills increases significantly, you may in fact see further spread widening and further reduction or lower use of the RRP. So, 2016 in terms of supply is going to depend on what happens with respect to T bill issuance."
He continues, "The Treasury has a unique opportunity to capitalize on this demand and supply imbalance on the front end. The further advantage is, of course, the Fed does not want to see daily use of the reverse repo facility in excessive amounts. If there is a competing product out there that could crowd out demand for the RRP, i.e. Bills, then the Fed would be happy to take the cap down on the RRP and steadily, over time, eliminate the program."
On demand, Abate highlights the major sources of new demand. The most notable is money fund reform driven flows. He asks, "How much money is going to leave Prime Institutional funds because the investors don't like the idea of fees gates and floating NAV? That's anybody's guess. My sense is to be conservative and assume a couple hundred billion dollars, because if the fund generates a high enough yield, it may overcome the institutional investors' displeasure with an emergency fee and gate structure, especially since fee and gates don't apply unless there is a major catastrophe."
The second potential source of flows is from bank deposits. He explained that there are two types of deposits -- retail deposits and non-operating corporate balances. The Barclays strategist expects banks to hold on to the former but shed the latter. He adds, "The institutional money will leave banks and head for the closest substitute for bank deposits, Government-only money funds." He summarizes, "Basically we're talking about a substantial increase in demand for safe assets -- somewhere on the order of maybe $500B this year."
JPM Securities Teresa Ho provided an overview of supply in the session, "Instruments of the Money Markets Intro." She comments, "At its peak in early 2008, total money market supply was about $11.5 trillion. Excluding Treasuries, credit supply peaked in 2008 at around $9.5 trillion. Fast forward to today, total money market supply has come down to roughly $8.5 trillion in terms of total MM supply, and $5.5 trillion in credit supply. So, there has been a dramatic $4 trillion drop in credit supply over the past few years."
She says it is driven largely by two factors, banks deleveraging their balance sheets and regulations. This is impacting the money markets, particularly CP. Ho says, "At its peak in 2006, the CP market was about $2 trillion with over 50% of that in ABCP. But in 2007 there was a collapse in the SIV and since then this market has fallen by the wayside.... Another example is repo. At its peak, this market was almost $6 trillion, now it is roughly half of that. It suffered through severe liquidity pressure during the financial crisis and even more so now in this post regulatory world."
Ho contrasted the downward trend in supply with the stability of demand. She comments, "Over the past 4-5 years, their [money fund] assets have been relatively stable across all different classes. Even if we take it back to September 2008, the cumulative change in their balances from that time period to today is only $500 billion." If the same calculation is applied to the supply side of the equation, the cumulative change from September 2008 to today is about $2.7 trillion. Ho adds, "This imbalance is in part one of the reasons why money market rates have been trading so low over the past few years. But that is about to change."
She elaborates, "We estimate that somewhere between $600-650 billion will flow out of Prime funds into something else, most likely into Government funds. Why does that matter? When you look at Prime money funds and what they invest in, about 60-70% of their assets are currently being lent to banks either in form of CP, CDs, ABCP, or Repo. `In dollar terms they lent out $1.1 trillion to banks on any given day." When that is pulled back, rates are going to respond accordingly, she said. "Banks are going to have to aggressively compete for Prime money funds, so they are going to offer a higher interest rate to do so. Naturally, we would expect that to move higher as money fund reform unfolds and cash starts to move out of prime funds."
Ho continues, "As the Fed moves its corridor higher and higher with interest rate movement, will short-term rates respond correspondingly? If they move up by 25, will bill also move up by 25, will CP rates rates also move up by 25? More importantly, with the new tool they have implemented, the ON RRP facility, will that serve as the floor for money market rates?" She concludes, "Ultimately, despite the fact there are a lot of cross currents in the space, I would still say that money markets are here to stay. Regulations may change the structure of the entire market, but as we've seen, the market will continue to adapt and evolve."
Finally, in the session, "Credit Analysis and Portfolio Management," SSgA Senior Portfolio Manager Todd Bean discusses the process and objectives of managing money funds. He says, "The two primary objectives that guide cash management are preservation of principal and liquidity to accommodate your clients' cash flow needs. If the strategy you're in doesn't meet these objectives, then either something has gone drastically wrong in the market, the investment manager has made a horrible mistake, or the strategy has been mislabeled to begin with. Meeting these objectives is what allows our clients and us as portfolio managers to sleep well at night knowing that that cash has been invested safely and prudently."
Bean explains, "Typically, to help insure we've met the preservation of principal objective, portfolio managers use a combination of high credit quality assets and short duration assets when constructing a portfolio. Many investment managers have in house credit research staff that control credit exposure in the funds through their use of an approved list of issuers. At that point, the PMs execute the trades off that approved list. They'll also typically establish maturity restrictions and asset limits for each of the credits as well."
Bean says, "PMs also use a variety of strategies to meet the liquidity objectives, like laddering maturities and diversifying the funds' purchases across a variety of liquid products." He adds, "Liquidity in the marketplace isn't what it used to be. Tighter regulations have clearly changed the balance sheets for banks and broker-dealers -- this makes meeting the liquidity objective more challenging than ever. Finally, we strive to provide a strong relative rate of return once we've insured that we've met the two primary objectives."
