Rates, regulation and the dash for cash

Read this article to understand:

• What could happen to liquidity yields if cash rates fall
• Whether the dash for cash will continue in 2024
• How technological change might impact liquidity

Rates at decade highs. A “likely” recession which refuses to materialise. The next 12 months presents liquidity investors with something of a conundrum.

Nevertheless, we remain constructive on the asset class. Strategically, cash yields look set to remain high; not only high, but above inflation to offer positive real yields. The diversification and high credit quality liquidity funds offer can mitigate adverse economic effects. The prospective combination of low risk and inflation-beating returns may give capital allocators pause for thought.

In particular, the prevailing wisdom over the last 15 years of abundant central bank liquidity providing support to risk assets could come under question. Tactically, the “option” value of cash is likely to remain high in 2024, offering investors the liquidity they need to deploy effectively into markets.

In this Q&A, Alastair Sewell, liquidity investment strategist, answers the key questions we are getting from clients.

What’s the outlook for inflation?

Inflation is falling and set to fall further. However, it remains high and above central bank targets. Official and private sector forecasts converge on inflation of around two per cent in 2024. Indeed, the UK’s latest inflation print, at 3.9 per cent compared with a consensus market estimate of 4.2 per cent, suggests the UK is well on its way to a return to target.

Much of the decline in headline inflation has been due to the decreasing effect of higher energy and food prices. Services inflation remains stickier, and closely linked to underlying labour market conditions. Our House View 2024 Outlook anticipates the pace of the decline in inflation to slow from here. 

Central banks are highly focused on the transmission mechanism to the real economy. For example, the increased share of fixed-rate mortgages in many countries means there is a lag between policy rate changes and effects on consumers. Similarly, termed-out corporate funding has delayed the impact of higher interest rates on some businesses. Ultimately, however, there will be a reckoning as increased borrowing costs pass through to the real economy. Which brings us to our next question.

Is a recession coming?

As highlighted in our House View 2024 Outlook, we believe that recession will be avoided in most major economies, although growth is likely to be below trend. For the euro zone and the UK we expect growth to be modest at best, with risks to the downside.

This means the prospect of a technical recession – a quarter or two of economic contraction – cannot be ruled out.

The threat of recession, in combination with falling inflation, raises the prospect of rate cuts.

What will happen to liquidity funds if rates start to fall?

Rate cuts are priced in across markets, although there is uncertainty on the pace and magnitude (see The 2023 scorecard). However, the amount of cuts the market expects is limited: we expect the long-term interest rate environment will be very different to the period following the Global Financial Crisis.

Market forecasts indicate interest rates falling to around 4.5 per cent in sterling, 2.5 per cent in euros and 4.25 per cent in US dollars in 2024. For reference, these levels are relatively “normal” by historical standards – the long-term averages in the UK and US are 5.23 per cent and 4.83 per cent respectively.¹

Money market fund (MMF) yields will inevitably settle to the lower level driven by central bank rates. However, we expect a substantial lag between rate cuts and MMF yields decreasing due to funds’ ability to actively manage exposures. By buying longer-dated, higher-yielding securities, MMFs can slow down the rate at which they re-invest into newly issued lower-yield securities.

History shows MMFs can deliver on this objective effectively. For example, there was a ten–11-month lag between rates being cut below zero and MMF yields turning negative in 2014-15.

Standard MMFs are structurally better equipped than short-term MMFs to delay the effect of falling rates. These funds can invest over a longer time horizon and, all else being equal, are better able to lock-in higher-yielding securities for longer. We expect investors to increasingly use blended liquidity strategies in this environment, splitting investment across short-term and standard MMFs to benefit from higher yields while preserving a low aggregate risk profile.

Will the “dash to cash” continue?

MMF assets achieved record highs in 2023. In the US, assets reached $5.8 trillion as of end-November 2023.² In Europe, we estimate assets reached $1.75 trillion, based on Lipper data.

In our view, a lot of this money will stay in MMFs, if not grow further. In the context of febrile market conditions and high interest rates, MMFs will remain attractive for many investors as a real yield-generating and liquid safe haven.

Notwithstanding substantial overall growth in MMF assets, the picture has been different in sterling. By our estimate, total sterling MMF assets fell around 15 per cent in 2023 to end-November.

Two structural drivers underpinned this. First, sterling MMFs experienced significant inflows in late 2022 following the mini-budget market dislocation. Over late 2022 and early 2023, these assets flowed out of MMFs as investors re-deployed into other asset classes. Secondly, the retail segment is essentially absent in sterling. This contrasts sharply with markets such as the US, where there was around $2.3 trillion in retail MMFs as of end-November 2023, around 38 per cent of total assets.

Will Europe re-regulate liquidity funds?

The European Commission is broadly constructive on the functioning of the European MMF regulation.³ This matters because most MMFs are domiciled in the EU, primarily Ireland, Luxembourg and France, and then sold cross-border into the UK.

We think there will, however, be regulatory change eventually, following the lead of the US. US “prime” funds, akin to Low Volatility Net Asset Value (LVNAV) MMFs in Europe, must now have at least 50 per cent weekly liquidity.

Second, the UK is calling for changes. The Financial Conduct Authority is consulting on reforms to UK-domiciled MMFs, including increasing weekly liquidity to 50 per cent. While there are few UK-domiciled MMFs, changes to the Overseas Fund Regime could lead to offshore MMFs distributed into the UK being affected by onshore rules.^4,5

Third, a new European Parliament will form in 2024, with elections due in May. New political orientations, the potential for new officials in key roles and the fact many European regulatory bodies have called for stricter rules raises the possibility that the MMF file will be re-opened.

It is reasonable to expect any changes to take time. We think it unlikely to see material change in Europe before the elections and it will likely take time after that time before anything meaningful happens. We will update our investors as soon as any developments occur.

What next for ESG and liquidity?

The European MMF industry moved decisively to Article 8 under the Sustainable Finance Disclosure Regulation (SFDR) in 2023. Article 8 financial products are those “promoting environmental or social characteristics”. By our estimate, around 70 per cent of European MMFs were Article 8 as of end-November 2023. Among LVNAV MMFs, the figure is almost 80 per cent in sterling, although lower in US dollars.

Investors using funds’ SFDR status as a differentiating tool may need to consider additional metrics. We advocate a close review of fund holdings and greater attention to the manager’s track record. We have produced a compendium of works providing information on exactly how to do so.

The SFDR came into effect in 2021. Since then, additional provisions have come into effect. Notably, from 2023, funds have to disclose additional information in their pre-contractual disclosures and report periodically on these, which provide useful information to investors and help them to differentiate funds.

How might technological change affect liquidity funds?

“Not much” is the short answer. We do, however, see interesting developments in this area.

The first is in blockchain technology. This can bring many benefits in terms of investment and distribution. There are examples of commercial paper being traded on the blockchain. This brings greater accuracy and near-instant settlement. Contrast that with the two-day settlement period for many market securities. However, this only addresses frictional liquidity. Where securities are not trading at all, the fact they can settle faster is irrelevant.

From a distribution perspective, tokenised units of fund shares may catch on with investors, but we suspect more so in other areas of the market. The fact MMFs can already provide same-day liquidity is substantially better than many other asset classes in which a two-day settlement period is the norm.

The second area is artificial intelligence (AI). All MMFs must adopt rigorous credit standards under the regulation. For most providers, that means a large and experienced credit research team digging through company fundamentals to assess risks and opportunities. We believe the combination of humans and machines should enable more assessments and faster.

The third area is large language models. For readers who have reached this far, it will not be lost on you that someone wrote this. As that someone, I can tell you it took considerable time. Could a generative large language model have produced this faster? Almost certainly. Could it have done it better? My ego says no, but will leave it to you to make your own judgement.