State Street Global Advisors hosted a webinar last week entitled, "Cash Solutions for the New Reality," where a panel of experts discussed a range of money fund related issues, including fund flows, the path of the interest rates, repo, ratings, and yield spreads. The session was moderated by Yeng Butler, Head of US Cash Business at SSGA, and featured commentary from Pia McCusker, Global Head Cash Investments, and William Goldthwait, Sales Strategist. We review the webinar below, and we also discuss this week's FOMC Meeting, the Federal Reserve's first since their December 2015 meeting, when they raised rates for the first time in almost a decade.
SSGA's Goldthwait discussed the migration of Prime to Government assets that has been taking place in preparation for the new SEC rules to take effect on October 14, 2016. He said, "Since the beginning of 2015, we've heard from many asset managers announcing they will not be supporting certain prime funds within their own shops in the new regulatory environment and thus will either close those funds, sell those funds, or convert them into government strategies ... the preferred option for many asset managers.... This makes sense given the cost and operational challenges that are involved in prime strategies. So far, we've seen more than $200 billion moved out of the prime strategies and converted to government money fund strategies. The key here is that this has been driven by asset manager conversion and not client driven moves."
He continued, "The wild card is how much of the remaining $1.25 trillion in Prime strategies will move? At SSGA, we've seen solid growth in our prime strategies throughout 2015; in fact, we're at an all-time high in asset under management in those prime strategies. You can be sure that in 2016, our portfolio management team will be very vigilant to ensure any shift in AUM is managed with relative ease."
Goldthwait also shared his perspectives on potential yield spreads between Prime and Government funds. He commented, "I tend to be less bullish about wider spreads than I once was due to all of the excess liquidity that Prime money market funds must own. As we know, the 7-day liquidity buffer in a Prime fund will be 30% of asset under management when the new rules go into effect in October. A drop below 30% will trigger a board notification and the potential for a gate or fee. I think it's safe to say that portfolio managers will run their liquidity buffer well above that 30% mark to avoid making that call. Does that mean 35%, 40%, 45% of the liquidity buffer?"
He explained, "I think it's too early to say. But when we looked at 10 of the largest Prime money market funds on various different dates last year, they were all running above 35% and some had as much as 50% of 7-day liquidity. So, the reason I'm less bullish on wider spreads is because in order to attain 40%, 45% of 7-day liquidity, you have to own a lot of short term repo, Treasury bills, or discount notes that will qualify in that liquidity bucket. Those are the same securities that some of the government funds will own as well."
Goldthwait added, "We know that Prime funds will continue to be a core product in the money market fund complex. How investors view and implement their Prime strategy in 2016 will be driven by three things. One is the Fund Deadline -- some prime funds are going to have to close a little bit earlier in order to process that variable NAV. The second thing is the Variable NAV, and lastly are Liquidity Fees and Redemption Gates. We've spoken to clients that feel comfortable with all three of those attributes and have expressed that they will remain in prime funds. We've also spoken to others that are not comfortable with one or all of those and will move to a Government or Treasury fund. Some clients have also expressed interest in the yield spread and will base their investments on that spread. We have some clients that are looking for just slight incremental yield over a Government product to remain in Prime, and then we have others that are looking for a very large yield spread between a Government fund and a Prime fund."
McCusker talked about the new SEC rules that remove references to credit ratings in money funds. She said, "This might alarm some investors that are conditioned to looking at ratings only. But rest assured, here at SSGA we have no plans to change our process or conservative nature with regard to credit. We've always had an independent credit research function that has successfully served our clients well, and we will remain true to what's served us well the last 30 years -- solid fundamentals with a focus on principal preservation and access to liquidity."
Goldthwait also commented on the importance of the Fed's Reverse Repo Program. He explained, "The reverse repo program is very important in the market because it allows money funds and other approved counterparties to loan money to the Fed and receive U.S. Treasury securities as collateral. Registered money market funds that are larger than $5 billion in AUM are eligible to apply to this program. We have 6 money market funds that participate daily. We find the program very helpful in establishing a floor on short-term rates, particularly at month-end and especially at quarter-end when broker-dealer balances are reduced and broker dealers are not offering other short term investments due to quarter-end balance sheet constraints."
He added, "The Fed ultimately would prefer not to have this program utilized. They don't want to be the lender of last resort in times of market stress, so it's anticipated that when the Fed does the unwind their quantitative easing balance sheet and starts to reduce the over $2 trillion in Treasuries they currently hold, short term rates will drift higher.... Ultimately, participating in the Fed reverse repro program will not be the most attractive option in the short term market."
He also explained changes to the repo market, which could impact Government funds. He told the webinar, "Although it does not impact our clients directly, they should be aware of the procedural changes that have taken place in the repo market, specifically, the tri-party market. Historically, before repo reform was implemented, the tri-party repo market was actively traded up until and even after 5pm. This allowed government money market funds, specifically, to remain open until 5pm because they could utilize this tri-party market to meet any shareholder activity. `But with repo reform, the process has changed. Deadlines have been implemented and there is very little, if any, tri-party repo trading after 2pm. So what government funds need to do now is leave cash uninvested in order to handle client redemptions. Leaving cash uninvested did not mean much when yields were near zero as there was very little opportunity cost there, but as rates start to rise, we might see potentially yield gaps on Government funds that close earlier vs. those that continue to close at 5pm. So now our clients should be asking themselves: How important is it to have a fund that is open to 5 pm?"
Finally, McCusker discussed the projected and expected path of interest rates in 2016. She said, "Our official house view is 4 interest rate hikes this year, and that's in line with the Fed's dot plot.... But right now, the Fed funds futures market is pricing in a probability of 24% for a March rate hike; this was about 50% post the December meeting. So, clearly the market is pricing in a much lower assumption." On whether or not bank deposit rates will increase with Fed rate hikes, she added, "I would expect banks to lag deposit rate increases by at least a couple of Fed rate hikes until some form of rate normalization is in place."
In other news, the Federal Reserve's FOMC met yesterday and, as expected, held the line on rates. The Fed's Statement says, "Given the economic outlook, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.... In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data."
