RBC Capital Markets' Michael Cloherty writes in his latest "US Interest Rate Focus" on "Money market update: LIBOR, SIFMA, RP, Fed funds." He says, "The money fund reform driven LIBOR distortions that we have been discussing for ages are materializing a bit earlier than we expected. The two major surprises are that the Institutional Prime fund outflow started earlier than our mid-August expectation. That said, we continue to believe that the biggest outflow risks will kick off in early September when everyone is back in the office and final decisions on where to park cash are likely to be made." We excerpt some of Cloherty's recent comments, and also quote from a new piece by Wells Fargo Securities on Commercial Paper.
Cloherty explains, "The other surprise is that Retail Prime outflows have continued. We thought that the bulk of the retail adjustment would take place in Q1. Yet outflows persist. We think of the retail prime space as providing an investor cushion amid what could be rapid outflows from the institutional funds in September and early October. The smaller retail prime becomes, the less that investor base will be able to close the gap created by shrinking institutional funds."
He says that "Uncertainty is the biggest problem," commenting, "We caution against being overly concerned with how much cash has left money market funds to date. We believe the most important factor behind higher LIBOR rates is not the outflow that has happened, but the massive uncertainty about the outflow that is going to happen in the coming months. There is no solid framework to forecast the total Prime outflow through when the reforms become effective on October 14th."
The RBC piece continues, "For money fund portfolio managers, the most difficult part is that they cannot position their portfolio for what they believe is the most likely outflow -- they need to have enough liquidity to meet the absolute worst-case scenario. Any money fund that had larger outflows than anticipated would have to get a cash bid from a dealer to meet its redemption requests, and in this environment assuming that there will be spare dealer balance sheet when you need it is a bad idea."
It adds, "This means the Institutional Prime money funds need to hoard enough liquidity to meet the worst-case outflow. Funds have been starting to set up for these liquidity needs by shortening the maturity of the positions in their portfolio. According to Crane Data, the best source for detailed money fund data, the Weighted Average Maturity of Prime money fund assets was 22 days on June 30th. Meanwhile, because Treasury and Government funds do not need to hoard liquidity because they will be getting inflows rather than outflows, their average WAM was 37 days for government funds and 40 days for Treasury-only funds."
Finally, Cloherty writes, "Unfortunately, that maturity differential compresses the yield spread between Prime funds and Government funds, which gives investors less incentive to remain in Prime funds. The greater the probability of a December rate hike that the market prices in, the steeper the money market curve, and the more difficult it will be for Prime fund yields to be significantly higher than Government fund yields."
In other news, Wells Fargo Securities' Garret Sloan and Vanessa Hubbard published a new "Money Market Monitor" piece entitled, "How is Money Market Fund Reform Impacting the Commercial Paper Market?" It says, "Commercial paper ("CP") rates, specifically in the financial sector have risen sharply due to a general increase in rates initiated by the Fed and a shift in money market fund ("MMFs") assets from prime to government. Commercial paper is a large and important component of short-term markets and a prevalent asset class in prime money market funds. With the impending MMF reform just months away, there are increasing implications for the commercial paper market, and more specifically for financial CP. We will look at historical trends for commercial paper and money market funds to provide an outlook on how the sector may be impacted by upcoming changes in the money market landscape."
Sloan and Hubbard tell us, "Commercial paper is a significant short-term asset-class with supply hovering around $1.0 trillion since 2010. Despite the overall stability of commercial paper assets, the composition has continued to shift away from the asset-backed ("ABCP") sector and into the non-financial sector. Since 2010, ABCP has declined by $190 billion and financial commercial paper has declined by $86 billion while non-financial commercial paper has increased by $160 billion. More recently, over the past year, financial CP has averaged about $523 billion. Nonfinancial CP has averaged about $277 billion and asset-backed commercial paper has averaged about $245 billion. The takeaway is that even though the composition of the market is shifting, overall CP supply appears to be relatively intact."
They explain, "CP is an important funding source for financial institutions and corporations as well as a significant asset class for short-duration fixed-income portfolios, including money market funds. Based on the past few years of June holdings data, money market funds have purchased about 37 percent of all commercial paper outstanding. However, that dropped to 28 percent in 2016, or a decline of around $100 billion. The drop in the level of CP concentration amongst money market funds while total CP outstanding has remained flat could be seen as a net positive for the sector. This may suggest that total CP issuance has been absorbed easily by non-money-fund investors either directly or through separately-managed accounts."
The Wells piece says, "Total prime fund assets continue to decline as fund families convert from prime funds to government funds in anticipation of the impending MMF reform. While this has decreased MMF appetite for commercial paper, it has not eliminated it. Money market funds will continue to purchase CP for their portfolios, predominantly financial CP, however they may demand shorter-dated tenors as overall portfolio WAMs decline and an increased emphasis on maintaining very high weekly liquid asset ratios keeps durations short. This has impacted the shape of the commercial paper curve, the LIBOR curve and the near-term technical landscape of the money markets in general."
It adds, "Certain investors who once relied heavily on prime money market funds have decided to make either temporary or permanent adjustments to their short-term investment strategy due to MMF reform and are starting to consider alternatives, including government funds, direct investing, bank deposits, enhanced cash funds and separately-managed accounts. The recent stability in CP outstanding despite the drop in money market fund assets may mean that alternative channels for CP distribution are developing rapidly. Nevertheless, the stability in supply may be coming at a cost, as the backup in CP rates may have to find a new equilibrium level to attract investors to the asset class."
Finally, Sloan and Hubbard comment, "In short, we expect commercial paper rates to remain elevated and the term structure to steepen further going into the final phase of money fund reform. As discussed, issuers continue to need short-term funding and the CP market will remain an important component of issuer capital structures. The wild card in the stability of commercial paper outstanding will be financial issuers, and the extent to which issuers look to diversify funding sources or find that U.S. CP markets have become too expensive."
