Western Asset recently hosted a webinar entitled, "The Fed and Liquidity Markets – Is This Time Different?" The discussion features Western's John Bellows, Kevin Kennedy and Matt Jones, with the three focusing on short-term investments and "how the Fed shaped its response to the Covid-related economic downturn." On navigating current market conditions, Kennedy comments, "Obviously there are multiple forces which will lead towards rates moving a bit lower next year rather than higher. For the front end of the market, there will be a decline in Treasury bill issuance of ... significance. Early in the year, there will be a drop in the Treasury general account in order to pay for the new stimulus, which is now roughly about $900 billion.... That, along with the fact that the Fed is continuing to purchase $120 billion of securities on a monthly basis, leads to a technical situation in the front end of the market, which leads towards rates being a little bit lower than they were in 2020. That will lead towards rates such as SOFR, the Fed funds effective, perhaps LIBOR to a certain extent -- all of these rates moving a touch lower next year.... Also, there will be a bit of a decline as far as issuance on the part of both commercial paper and CD issuers next year. So that is certainly a challenge, but there is room for optimism."
He continues, "The Fed is in a situation where they are not comfortable with rates being consistently towards the lower end of their targeted range, which is zero to 25 basis points. They do have tools at their disposal to make sure that we do have rates remaining above zero.... The tools they have at their disposal include perhaps raising the rate on reverse repo where money market funds and the GSEs and banks can invest directly with the Fed and perhaps get higher rates. So, at some point they may move that rate from zero to five basis points. The Fed may also adjust IOER, interest on excess reserves, higher. Right now, it's 10 basis points and that might move to 15 basis points. They may want to keep that type of corridor. The Fed will be there certainly monitoring rates if they do start to flirt with that zero lower bound."
Discussing issuance, Kennedy says, "Even though bill issuance will decline, bill issuance last year increased by $2.5 trillion [and] Treasury note issuance increased by $1.4 trillion. There is already a huge increase in Treasury supply that's taken place last year [and] over years prior, and this coming year there will still be the need for a great deal of funding. Even though the Fed is not going to focus on Treasury bills to raise those funds, they will continue to raise the Treasury notes, and that will probably more than offset the decline in bill issuance. A continued increase in debt outstanding will lead to financing rates that will remain positive, so that is something that works towards rates staying above that zero lower bound.... I think we'll see more issuance from the commercial paper side, from bank product, and eventually we'll see rates perhaps even under some modest upward pressure at some point during the middle of next year."
Bellows comments, "If you think about the tools and the things [the Fed] rolled out in March, a lot of those were just the same that they had done in the previous crisis. There were some new ones, there were some red lines that were crossed. But they just used what they had done previously.... So, I think there's this real kind of ratchet effect in terms of, once they've introduced something it's now available to be reintroduced again. I just want to say that I think it's a big deal, and I think that suggests more Fed support for credit markets, for money markets ... than was there previously. Again, because they have crossed those red lines, there is a ratchet effect in the way that these programs are rolled out the next time after having been introduced.... So, I think that kind of Fed involvement in credit markets is going to be there."
He adds, "It's worth mentioning that money market mutual funds got kind of a special place in this. It was one of the first parts of the market that was backstopped with the liquidity facility where the Fed was making loans to banks that had bought assets from money market funds. And it continues to be singled out. A lot of the ... facilities are ending. Secretary Mnuchin ended the corporate facility, or will end it at the end of the year. But he singled out the money market fund facility to keep going another three months. He said he was doing that out of an 'abundance of caution.' So, the point here is that the Fed's involved, along with Treasury, in supporting these markets -- money funds maybe more than others."
Regarding the LIBOR and SOFR transition, Kennedy says, "On the money market side, we are seeing a much higher percentage of SOFR floaters issued relative to LIBOR-based. There are still LIBOR floaters being issued, we expect to continue to see that. I think that investors, including ourselves, will be somewhat less willing to buy any LIBOR floaters with a maturity on December of next year when it's expected regulators ... suggest or demand, certainly, that there be no more LIBOR related transactions or issuance. Several months ago, the GSEs stopped issuing LIBOR-based floaters. It's all SOFR at this point, though there could be some other indices, prime for instance, or bills."
He continues, "Money markets are getting used to it. There is certainly a basis swap element to it when you're trying to overlay some sort of credit component to SOFR. I think the investors are getting used to that, even though that's far from finalized.... We don't see much change except as far as percentage of our floating rate positions in LIBOR; they're much less, but they're still extremely liquid. We anticipate that LIBOR-based floaters will continue to be liquid until, say, the middle, or toward the end of next year. We're not shying away from them at this point, they do offer a greater relative value ... LIBOR will be around for a while. SOFR is getting a lot more attention as the months progress, especially as we get into the middle of next year. We think SOFR will have gone a long way towards representing an extremely high percentage of money market floating rate securities that are in the marketplace."
When asked, "Where do active fixed income managers find opportunities now?" Bellows answers, "One of the observations that we've made in our investment committees that Kevin and I are both on is, there's a pretty optimistic outlook in terms of the combination of above trend growth and accommodative policy, that's the good news. The bad news is a lot of the markets already reflect this and prices are already quite high, so spreads are tight, especially in front end corporates, for instance. We certainly recognize that challenge, and markets are forward looking they've kind of gotten ahead of that, and it's a challenge."
He continues, "One of the things to be really thoughtful about in terms of front end corporates is they now have this kind of uniquely high Sharpe ratio.... First of all, there is some risk premium there, just corporate risk premium or corporate credit spreads, and so you do need to earn a little bit more by being exposed to US corporate credit. The thing that's changed this year is I think they also have this backstop from the Fed. And as I said, I do think that there's an expectation that even if the facilities expire in December, that those backstops have now been established and could be redeployed if needed.... That means you're going to have a little bit less volatility, both because those backstops are available, but also because investors know those backstops are available.... Obviously, some of that's already reflected the level of spreads. We continue to think that is an opportunity."
Bellows also says, "I think it's a fairly compelling opportunity. It's an argument for maintaining exposure to a little bit of yield products in the front end of the yield curve. Whether that's in corporate credit or maybe even some structured credit, you know, having that combination of out yielding in potential total return from the yield, together with the lower volatility because of the backstops, I think it's compelling. I don't want to minimize the question because it's a really good one. Spreads are tight, that makes everybody's job harder. But I do think that thinking through the Sharpe ratio implications of what's happened suggests that there's still a case for further involvement."
Jones adds, "We have to talk about Prime money market funds. If you go back to March and April, the Financial Stability Board and agencies and regulators around the world are focused on many of the key market issues. Prime money market funds for a time there in March and April were in the spotlight, as some of the SEC's 2a-7 regulation introduced back in 2016 actually became part of the conversation. But again ... it wasn't about credit.... It was about liquidity. We firmly believe there's a place for Prime money market funds. But what are your thoughts around the future of prime investment moving forward?"
Kennedy answers, "March drew a lot of attention to money market funds. I think that you can make the argument certainly that there was a little bit too much attention.... All markets were basically frozen. I think money market funds had a disproportionate share of attention, but that's my personal view. It's obvious that after March money funds had to respond, perhaps ... in deference to what the regulators might be looking towards and what they might look to ask from Prime money market funds down the road as far as new types of regulations."
He explains, "Across the Prime fund space, we did what we think made our client base comfortable, which was increase our liquidity percentages. So, in our liquidity buckets, we might have run that close to 40% before March, certainly that became closer to 50%.... Also, when we're looking further out the curve, we were more inclined to buy securities that were eligible for the MMLF, the Money Market Liquidity Facility, and we think that added another layer of comfort to our client base. And certainly, as John said, those programs that are in place in this quarter of the fixed income markets ... that's something that also supports Prime money market funds, which I think is something that continues to make them attractive and a very good investment option."
Kennedy continues, "Probably overwhelmingly the most important thing in the marketplace today is the strength of the financial institutions that really make up the securities that we're buying into Prime money market funds.... That's the case for funds, that's the case for U.S. banks, financial institutions here in the U.S. and overseas.... This was certainly forced upon them by the regulators, but they certainly have much more in the way of capital. They've certainly moved away from more risky types of leverage-based enterprises.... I think at the onset of the crisis, there was a view that there would inevitably be some downgrades to some of the banks, if only because of a shift in the macro view and to a certain extent that did happen. There have been some modest downgrades, some negative outlooks. But really the underlying strong level of these institutions' capital bases has really offset those concerns."
Finally, Bellows adds, "As I said, I think the Money Market Fund facility has been distinguished as a really important one and Mnuchin singled it out.... Currently extending through March, it wouldn't surprise me if there's another three months as well. But I think the more important takeaway is that the Fed has demonstrated they do not want these markets to fail and they're going to continue to find ways to support them. And I certainly think that goes for money funds, but I think that can be said more broadly for credit markets."
