Fed And Money Markets: At The Crossroads Of A Mad Dash For Cash?

In money markets, months, quarters, and even years can pass with little fanfare. And then all of sudden, a new regime sprouts up and events shift rapidly. In my opinion, we have entered such an environment post the Fed’s emergency 50 bps rate cut. The dilemma is that the fuse is much shorter this time versus prior cycles following last year’s ‘insurance cuts’ – and also because the Fed barely made it to the half-way point in rates compared with prior tightening cycles. This, coupled with less short-term (S/T) investments relative to long-term (L/T) securities and the likelihood for cash to remain in demand if market vol stays high, may add to the angst.

Post GFC Shift Into L/T Debt Left The System With Few S/T Investments

As the saying goes, generals always fight the previous war (and market economists the last recession). In 2007-2009, a crisis in confidence quickly became a global liquidity and credit crisis as investors and traders started to worry about counterparty risk, roll-over risk and collateral value. This led to hoarding of cash and a fear of funding institutions, among other things.

In the post-crisis period, regulation and overall investor preference for seeking higher yields led to less short-term issuance. Even though credit markets have seen record growth in debt outstanding, commercial paper (CP) remains a fraction of the size it once was and has barely changed.

Chart 1: Corporates Relying Less on S/T Funding Means Less S/T Paper

Source: St Louis FRED, Macro Hive

Money Fund Balances Remain Elevated and Similar to Pre-GFC Levels

At the end of business cycles, the preference for cash tends to increase. Using retail and institutional money market fund balances on the FRED database, the size of the industry nearly doubled from 2007 to early 2009.

The initial wave typically comes from conservative investors pulling cash out of banks and seeking the higher returns that money markets offer (versus banks which lag at passing on rate hikes). However, it’s the second wave that is usually more telling of broader macro flow trends. In 2009, the big nugget was institutional money that started to pile up on the sidelines. And what do we have now since late 2018/early 2019? The same!

Some analysts may point to the fact that the US has the highest rates – an advantage that will keep fading if the Fed goes to zero interest-rate policy (ZIRP) – and that USD repatriation and a strong US economy is seeing cash temporarily warehoused in money markets before deployment.

I say, ‘nice try’. If that was the case, the time-series would not be smooth and upward-sloping. Meanwhile, one remaining issue, and one that I worry about tremendously (and highlighted above), is that there is not enough S/T paper in the system now. If money floods into money markets, it can end up back at the Fed’s balance sheet via the reverse repo program (which will create a whole host of issues that this short note cannot cover in detail).

Chart 2: Cash on the Sidelines Even After the Fed Stopped Hiking

Source: St Louis FRED, Macro Hive

How the Fed Can Help in Combating COVID-19 Without Flooring Rates

For the record, we are not a fan of the Fed going to ZIRP, but they probably will in short order (followed by a whole host of new/old easing measures).

Ideally, the Fed should not panic and take another ‘wait and see’ stance and use other alternative forms of easing that will get directly at the root of credit logjams in the system. Two tools come to mind. One is the discount window (DW) for banks (along with the primary dealer credit facility, a version of a DW for dealers – see here), and the other is the FX swap lines.

These tools are by design short-term in nature and were used effectively in both the GFC and at the height of the EU debt crisis. My preference would be for the Fed to provide cheap or no-cost loans to industries that will suffer cashflow shortfalls from supply-chain disruptions/travel restrictions due to COVID-19. And given that it’s a dollarized world, similarly, if COVID-stricken firms overseas need temporary USD, they should be able to get them directly from their central banks which will source USD from the Fed.

Chart 3: The Fed Has Many Tools to Provide Liquidity and USD Access

Source: St Louis FRED, Macro Hive

Conclusion

It’s still early days in the assessment of how COVID-19 will impact industries, the banking system, and the economy at large. This will result at times in vol shifting to the front-end as cash products rally and funding spreads could widen. Meanwhile, in a worst-case scenario, the Fed needs to stop buying T-bills as money funds will need access to that collateral. The US government will continue to borrow more debt, and although now is the time to extend the maturity duration, given cash needs, they need to keep issuing a ton of T-Bills. Otherwise if there is further a flight to safety into money funds that cash will end up turning around and encumbering the Fed’s balance-sheet via the RRP. Nobody ever said this would be easy.

George is a twenty years fixed income markets veteran. Over that time he has covered rates, structured products and credit. He worked both on the buy-side and sell-side.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)