The Bank of England recently published, "Financial Stability Report - July 2021," which "view on the stability of the UK financial system and what it is doing to remove or reduce any risks to it." Under section "3.2.1: Limiting the demand for liquidity rising unduly in a stress period," they write, "The March 2020 market disruption highlighted how a 'flight to safety' in financial markets can lead to an aggregate increase in demand for liquidity and become an abrupt and extreme 'dash for cash'. Vulnerabilities within the financial system can exacerbate this demand for liquidity, including: the mismatch between the liquidity of assets held in open-ended funds -- including MMFs -- and the redemption terms offered by those funds; the forced unwinding of leveraged positions by non-bank financial institutions; and the management of liquidity demands following increases in derivative margin calls."
A section on "Examining and addressing the liquidity mismatch in funds," tells us, "There is a need to examine and address the mismatch between the liquidity of assets held in open-ended funds -- including MMFs -- and the redemption terms they offer. In December 2019, the FPC set out three key principles for fund design that, in its view, would deliver greater consistency between funds' redemption terms and their underlying assets: Liquidity classification: The liquidity of funds' assets should be assessed either as the price discount needed for a quick sale of a representative sample of those assets or the time period needed for a sale to avoid a material price discount. Pricing adjustments: Redeeming investors should receive a price for their units in the fund that reflects the discount needed to sell the required portion of a fund's assets in the specified redemption notice period. [and] Notice periods: Redemption notice periods should reflect the time needed to sell the required portion of a fund's assets without discounts beyond those captured in the price received by redeeming investors."
The report explains, "For open-ended funds, the FPC has judged that the mismatch between the redemption terms and the liquidity of some funds' assets means there is an incentive for investors to redeem ahead of others, particularly in a stress. This first-mover advantage has the potential to become a systemic risk by creating run dynamics. The Bank and FCA have been conducting a joint review into vulnerabilities associated with the liquidity mismatch in open-ended funds, which included a survey of UK-authorised open-ended funds and their liquidity management practices. The FPC welcomes the conclusions of that review."
It continues, "MMFs are a particular form of open-ended fund. Investors tend to use MMFs as part of their cash management strategies because MMFs offer 'same-day' liquidity -- meaning investors can generally expect to redeem their full principal at any time. Although many investors regard their MMF holdings as cash-like assets and generally redeemable on demand, they are subject to the risk of losses because MMFs may not be able to make good on this expectation in all circumstances. The 'dash for cash' episode highlighted structural vulnerabilities in MMFs."
The Bank of England's Financial Policy Committee says, "In March 2020, prime MMFs -- those that invest largely in non-government assets -- faced significant outflows and found their ability to generate additional liquidity constrained, exposing the risk of a run on these funds (see 'Assessing the resilience of market-based finance'). Such a problem in one fund risks contagion to other funds, and thus could lead to a highly destabilising run on MMFs."
They state, "Suspensions of redemptions by MMFs could have had potentially severe implications for UK financial stability and the economy, due to their interlinkages with other financial institutions as well as with corporates and local authorities. These consequences were avoided by central bank interventions that alleviated demand for liquidity across the financial system."
The report also tells us, "To address vulnerabilities in the global money market fund sector, a robust and coherent package of international reforms needs to be developed. One of the most important vulnerabilities to address is the liquidity mismatch inherent in MMFs that hold assets which are not liquid in stress. Potential ways to address this range from -- at one extreme -- increasing the range of stress scenarios under which MMF assets remain cash-like (such as limiting funds' asset holdings to government instruments only), to -- at the other extreme -- recognising that certain MMF assets are not cash-like in stress (by, for example, requiring notice periods for redemption)."
Finally, it adds, "Within this range, it is possible that a set of measures could be used to reduce risks to a sufficiently low level and make MMFs resilient for the purpose for which they are used. In addition, any reform package should remove the adverse incentives introduced by liquidity thresholds related to the use of suspensions, gates and redemption fees (see Bailey (2021)). Recognising the global nature of financial markets, any work to assess and ensure the resilience of MMFs should continue to be co-ordinated internationally. The FSB has published a consultation paper which sets out policy proposals to enhance MMF resilience. The FPC welcomes this consultation paper."
In other news, earlier this month Federated Hermes published, "Powell calm despite inflation storm." Federated's Sue Hill comments, "The inflation debate rages on. Price pressures were on full display this week with the release of CPI and PPI for the month of June. What wasn't so clear, however, was whether they will meet the Federal Reserve's definition of inflation. We should be careful not to attach too much significance to the year-over-year measures of price data because they still fall under base effects from sharp price declines 12 months ago. But the month-to-month data is telling. The 0.9% change in CPI was well above expectations, powered by an astounding 10.5% rise in used car prices and additional pressures in airfares, lodging and restaurant meals."
Hill writes, "Chair Powell seemed pretty unbothered by it all during his appearances on Capitol Hill this week. He acknowledged the increases had exceeded the Fed's own expectations, but still believes that much of the pressure will subside. We even got some sense of how patient the Fed could be. He defined inflation as, 'Year after year after year, prices go up', and left the impression that it could take six months before the Fed would conclude that what it suspects is transitory might actually be more structural in nature."
She asks, "Is this wait-and-see approach wrong? Is it risking 70s style inflation? I don't think so. While there surely will be more structural inflation in some sectors when the dust all settles, we may be seeing the peak in prices for some areas that have been supply constrained. And, of course, the Fed also has a full employment mandate. While how the Fed measures that in the post-pandemic world is not entirely known (perhaps even by the policy-setting Federal Open Market Committee), it's not at the level at which we are today."
Hill concludes, "If substantial progress is made toward full employment over the next six months as supplemental unemployment benefits end and schools return to in person attendance, the Fed will be willing to start to remove policy accommodation even if the verdict on the permanence of inflation is not yet in. I think many officials are no longer comfortable with the current pace of asset purchases as they have not been needed for the purpose of supporting market functioning for quite some time. So in the fourth quarter, we expect them to outline their taper plans, which should include both Treasuries and agency mortgage-backed securities."
