Liquidity outlook for 2025

Read this article to understand:

• Why conditions for credit, liquidity and yield appear clement
• The various options available for investors seeking to generate higher yields in an overall declining rate environment
• Why regulation remains the main uncertainty surrounding the sector

The global economic picture may be increasingly varied, but credit conditions remain benign overall. That should be a positive for liquidity funds.

While central bank rates – and hence liquidity fund yields – may not match the highs of 2024, we still expect levels of cash income to be healthy in 2025 and certainly well above the lows of the 2010s.

Nonetheless, we believe “step-out” strategies such as “standard” money market funds (MMFs) and ultra-short bond funds, could be useful tools in 2025 for those investors able to access them. These can help investors achieve higher overall blended yields while maintaining good levels of liquidity.

The complicating factor will be on the regulatory front. We expect announcements on European liquidity fund regulation in 2025, but the when, what and how of those changes remain to be seen.

Credit conditions: Benign

We expect favourable credit conditions in 2025. While there is increasing variability in economic performance and challenges in finding growth in some markets, economic forecasts remain broadly positive overall. This provides a solid base for credit conditions (see Figure 1).

For banks, the mainstay of liquidity fund allocations, these economic conditions are broadly favourable. While nomenclature and presentation vary across the major credit rating agencies, the core view is that conditions are neutral for banks (see Figure 2). This indicates that rating agencies do not expect material credit deterioration – or downgrades – over the next one-to-two years.

This fundamental picture is reflected in credit spreads, which are tight across major indices. Default rates are widely forecast to remain low in 2025, although it is worthwhile pausing to reflect on the incidence of bank failures over the years. The key point is: banks do fail. By assets, 2023 was significant on this front in the US, and of course in Europe too with Credit Suisse. Well below the levels witnessed in 2008-2009, however (see Figure 3).

The moral of this story is simple: while credit conditions may appear benign, issues can still occur. A rigorous and repeatable credit process is critical at all times.

Liquidity: Solid

Liquidity has been a major focus area in 2024, following on from the implementation of new regulatory rules in the US (requiring 50 per cent weekly liquid assets for institutional prime funds) and a consultation from the UK’s Financial Conduct Authority (FCA) proposing 50 per cent weekly liquidity for all MMF types.

While such high levels of liquidity may reassure policymakers and investors, a more practical question is whether liquidity funds really need such high levels of liquidity at all.

Our 2024 observations for low volatility net asset value (LVNAV) MMFs (based on iMoneyNet data):

• Average daily flow: +0.2 per cent
• Average weekly flow: +1.1 per cent

The fact that averages are positive should come as no surprise given the magnitude of inflows to liquidity funds during the year (see Figure 4).

Despite flows being broadly positive during the year, liquidity funds have maintained high levels of liquidity. For example, the Aviva Investors Sterling, Euro and US Dollar liquidity funds averaged 37 per cent weekly liquidity at end-November 2024. Well above the 30 per cent minimum required for LVNAVs.

Looking back at the prior episodes of stress – notably March 2020 at the onset of COVID-19 – there were substantial outflows from some funds. However, flows only exceeded 30 per cent weekly in US dollars and that we would attribute primarily to currency-specific investor effects.

Looking ahead, we focus on corporate cash balances as an indicator of demand on liquidity. In Europe corporate cash balances increased in 2024, while in the UK balances were broadly stable. With stable-to-growing corporate cash balances, liquidity funds could legitimately operate with lower levels of liquidity. However, we expect we will maintain liquidity well above regulatory minimums in 2025 primarily as a matter of prudence.

Yield: Reliable income

Most major central banks are in a rate-cutting mode, although the timing and pace of cuts remains subject to considerable variation. This will put negative pressure on money market instrument yields. The key challenge for liquidity fund portfolio managers will be in predicting the timing and magnitude of future rate changes and hence the relative value of securities with different maturities. In other words, it’s all going to be about the shape of the short-term yield curve. In 2024 pricing moved materially as market participants adjusted their expectations for future rate movements and this trend continued into the start of 2025. Figure 5 shows the main central bank rates on January 17, alongside forecasts for the next two years.

Looking at 2025, market participants have adjusted their expectations. Take the US for example: in mid-November 2024 market participants were expecting three cuts in 2025. By early January 2025, market pricing suggested fewer than two cuts in 2025. Median forecasts from economists do, however, still point to cuts ahead, with inflation developments representing a key factor in the outlook.

The more fundamental point is that there is no current indication of rates falling back to the ultra-low levels of the 2010s. This means that liquidity funds are likely to continue providing a good level of income. Indeed, with inflation falling, and below central bank base rates, the yields on liquidity funds should be positive in real terms for the foreseeable future.

Positioning: Step-out considerations

There are options for those investors seeking to generate higher yields in an overall declining rate environment. Where investors can segment their cash into buckets, they may be able to allocate some into higher yielding near-cash vehicles.

Selecting “step-out” vehicles can be challenging because it usually means leaving the conformity of liquidity fund “land” and using ultra-short bond funds. For those investors unwilling to step outside the regulated liquidity fund perimeter, so-called “standard” MMFs can be an option.

These operate with longer weighted average maturities than “short-term” MMFs, such as LVNAVs, and can therefore generate potentially higher yields, especially as rates fall.

Short-term bond funds come in many shapes and sizes. Many will have material allocations to short-dated corporate bonds, potentially rated in the “BBB” category. While these securities can provide attractive yields, credit spreads are currently tight. A widening of credit spreads would be negative for the performance of funds with material allocations to these securities.

We believe there are assets with more stable profiles available which can deliver incrementally higher yields. These will typically be higher credit quality (e.g. rated ‘A’ or better) and low duration, thus making them less sensitive to credit spread or interest rate volatility. Assets like covered bonds, for example, are an important allocation in our Liquidity Plus and ReturnPlus funds.

Regulation: Action stations

It’s virtually impossible to write about liquidity funds without talking about regulation. They are one of the most heavily regulated mutual fund sectors.

The difference this time is that we expect material activity in 2025. We think it highly likely the European Commission (EC) will put forward proposals to change the MMF regulation in 2025. We’ll be briefing investors as and when there is news, but they key points we are expecting to come up are:

• “Delinking”: Or removal of the link between weekly liquid assets and the potential imposition of liquidity fees and gates. The EC has already indicated it is minded to remove this link as it proved to have unintended consequences. That’s a positive.
• Increased liquidity requirements: The Securities and Exchange Commission in the US mandated higher liquidity levels and the FCA in the UK has called for it. While the EC has stated that current levels are adequate, we see pressure from multiple quarters to demand more. This should make liquidity funds safer, but then again, the evidence shows that even in severe scenarios current liquidity levels have proven adequate to date. More fundamentally, it could well reduce the yield liquidity funds can generate.

Could there be more? Almost certainly. Watch this space.

Conclusion

In conclusion, we expect broadly favourable conditions for liquidity investors in 2025 driven by overall benign credit conditions. While yields may be lower than they have been, we expect them to remain materially higher than they were in the 2010s and hence continue to provide a good source of reliable income.

Nonetheless, where investors can, there are complementary products available which can help investors meet their liquidity management needs. As to the unknowns for the year, the main one must be regulation. We expect developments in 2025, but exactly when there are announcements, what those announcements are and how long will be allowed for implementation all remain, as yet, unknown.