J.P. Morgan published its "Short-Term Fixed Income 2023 Outlook" last week, and entitled it, "More supply and higher yields, what's not to like?" Authors Teresa Ho, Pankaj Vohra and Holly Cunningham tell us, "The sharp rise in rates this year was a welcome relief for the US money markets-markets that were plagued by the Fed's zero interest rate policy for at least two years. Even so, it was not all good news, as high inflation and tight labor markets pushed the Fed to embark on one of the most aggressive tightening cycles in modern history. In response, liquidity investors significantly shortened duration at a time when the supply-and-demand mismatch in the money markets was substantial.... [T]his pushed short-dated T-bills and SOFR to trade meaningfully through RRP.... All told, balances at the Fed's ON RRP continued to grow, increasing from $1.5tn at the start of the year to $2.1tn, as investors used the facility as a source of backstop supply, to shorten duration, and/or to ensure their yields stayed at or above RRP." (Note: JPMorgan's Teresa Ho will present the "Instruments of the Money Markets Intro" at our upcoming Money Fund University, which is Dec. 15-16 in Boston.)
The 2023 Outlook explains, "In 2023, we are more optimistic about conditions in the money markets. While the path of future interest rates remains uncertain, it appears the Fed's aggressive campaign is mostly behind us.... Fed funds is expected to peak at 5%, meaning 100bp more of tightening. In the grand scheme of things, this is not a particularly negative environment for consumer demand nor for credit losses as we enter into the most well-telegraphed recession in modern history."
It says, "In turn, this should give way for investors to extend out the curve, alleviating the demand for very short-dated money market products, including MMFs. At the same time, money market supply is expected to pick up meaningfully (+$1.6tn), with T-bills leading the charge. We should also see incremental supply come through in the form of repos, discos, and CP/CDs, as the Fed continues to step away as a buyer of Treasuries and MBS and drains liquidity from the system. Taken together, we should see the supply-demand gap in the money markets narrow sharply next year, draining RRP and allowing the Fed to continue QT."
J.P. Morgan comments, "Against this backdrop, MMF reform will continue to loom, though we expect it to be finalized soon. While this will have a detrimental impact on the prime fund industry, the financial impact on broader money markets will likely be more muted relative to the last round of reforms implemented in 2016. USD Libor will also fully sunset in June 2023, leaving market participants with SOFR and no accurate gauge of credit spreads going forward."
They continue, "Net, reflecting our macro outlook and technicals, we expect money market rates to continue to drift higher and pause at the end of the tightening cycle, in step with fed funds.... The T-bills and the CP/CD curve should flatten as investors begin to extend out the curve. SOFR should start drifting higher in the fed funds corridor, trading flat or above RRP. Spreads should widen as the supply-demand gap narrows. In the 1-3y sector, we like fixed versus floating given compelling breakevens."
The Outlook states, "Regardless of the resting stop, by the time the Fed is done with the most aggressive tightening cycle in modern history, cash yields should be around 5%. While inflation-adjusted yields will likely remain in negative territory, nominal yields (using MMF yields as a proxy) will likely reach levels last seen in 2007 when the fed funds rate was at 5.25%.... As we have seen this year, the high beta of rate hikes passed through in the money markets is allowing MMFs to effectively compete with stock and bond investments as well as bank deposits.... The former (stocks and bonds) has demonstrated substantial negative returns, while the latter (deposits) has barely passed on any of the rate hikes."
It continues, "To be sure, while taxable MMF balances have declined by about $110bn YTD, relative to their current levels ($4.9tn), the drop is tiny (-2.2%). Furthermore, MMFs tend to see seasonal inflows during the last two months of the year; so by year-end, balances could be even higher, offsetting the decline. Notably, prime MMFs have been the primary contributor to the relative steadiness in overall taxable AUMs, as retail and internal asset managers sought the safe havens of MMFs for stability and yield in the face of an inverted yield curve and very volatile equity and fixed income markets.... Meanwhile, government MMFs lost about $320bn YTD, reflecting, we think, some normalization of the last minute buildup of cash at the end of last year (+$238bn in 4Q21) and corporations making greater use of their cash as they've had to deal with inflation (higher input costs) and higher rates (higher borrowing costs)."
The piece summarizes, "In 2023, we see factors that argue both for higher and lower balances. We don't have a crystal ball, but on net, we believe MMF balances will be flat to down next year, though they will still be significantly above pre-pandemic levels. Below, we discuss some factors at play: Bank deposit yields: Deposit betas at banks will likely continue to be low relative to prior tightening cycles, even as deposit yields gradually rise next year.... As a result, the attractiveness of MMFs should continue to pull money away from deposits. Indeed, during the last two tightening cycles, MMFs continued to receive inflows even when the Fed paused. In fact, they didn't experience outflows until 6-9 months after the Fed began cutting rates."
JPM cites as negative factors, the "Increased use of cash: Grappling with inflation and higher borrowing costs, corporations appear to have been drawing down their cash to help fund their expenses [and] Curve extension: To the degree markets are anticipating the Fed to be on hold or even to begin easing next year, duration will figure more prominently in portfolio management discussions."
The Outlook adds, "While MMF AUMs should moderately decline next year, total money market supply is expected to substantially increase by around $1.6tn or ~12% in 2023, predominately driven by Treasury bills.... Meanwhile, we estimate credit supply (total ex-Treasuries) to increase by about $564bn or ~9% in 2023, thanks to QT contributing to additional Agency discos, Agency FRNs, and bank CP/CD issuance. In addition, we look for continued growth in non-financial CP outstandings, as corporate issuers look for cheaper financing in CP versus out the curve. If we're right, total supply balances would be meaningfully above their 3y averages, which should help narrow the supply-demand gap and drain some of the $2.1tn at the Fed's ON RRP."
Finally, they comment, "For better or worse, we began the year digesting SEC's reform proposal for MMFs, released in mid-December of last year. A quick 60-day comment period later, followed by two new SEC Commissioners being sworn in this past summer and a technological error in the SEC's system that prompted them to reopen the comment period for 14 days in October, it appears the industry will soon see a final rule from the SEC. At this point, we think a final rule could be released as early as December, though early 2023 seems more likely. Unfortunately, despite universal MMF industry opposition against swing pricing, it seems the SEC continues to be enamored with it. In fact, the SEC's latest rule proposal requires open-end mutual funds and ETFs to also use swing pricing as a form of liquidity management. Our best guess is that the final rule on MMF reform will impose swing pricing for institutional prime funds."
