Cash is king (again)

Read this article to understand:

• Why investors continue to be drawn to money market funds
• The impact of US banking sector woes
• Why US money markets could be poised for more volatility

The worst outbreak of global inflation in more than 40 years continues to exert a profound impact on financial markets. Nowhere is this more apparent than in money markets.

Major central banks’ efforts to quell inflation by pushing interest rates to their highest levels since 2008 is leading to a sea change in investors’ attitude on how they manage their cash.

In the US, the collapse of several regional banks led to huge flows into money market funds (MMFs) as savers sought a safer place to park their cash. At the start of July, assets in US MMFs hit a record $5.47 trillion, according to Investment Company Institute data; a similar theme is playing out across Europe.¹

And while the turmoil sparked by uncertainty over the outcome of debt ceiling negotiations has begun to die down, the market reverberations are likely to persist.

To understand how events are likely to unfold over the coming months, we put the questions to Rakesh Girdharlal (RG), head of liability driven investment and liquidity; Mhammed Belfaida (MB), head of short duration – liquidity; Demi Angelaki (DA), senior portfolio manager, liquidity; and Alastair Sewell (AS), liquidity investment strategist.

Inflation has proved more intractable than expected. How is this impacting money markets?

RG: Central banks have responded with rapid and sustained hikes in interest rates. This feeds through directly to the money markets. In sterling money markets, cash is yielding more than five per cent for the first time since the global financial crisis.

This fundamentally changes how investors look at MMFs. They are suddenly looking a far more attractive option than keeping your money in bank deposits, with banks having failed to pass on the full rise in rates to their customers.

Whereas before MMFs were largely the preserve of insurers and other corporations looking to manage cash, suddenly all types of investors, including retail, are showing an interest in MMFs. In the US, where it is easier for retail and wealth clients to invest in MMFs, inflows have been incredible. As for institutional investors, when making strategic asset allocation decisions, cash is considered an asset class in its own right.

Previously, many investors would not have considered MMFs. Two years ago, both bank deposits and MMFs would have been returning close to zero. The only way to boost returns was to hold, say, three or five-year investment-grade credit which, relative to cash, was yielding appreciably more. As interest rates have risen, the value of these investments has fallen. This is forcing everyone to review cash-type investments. MMFs can suddenly offer more attractive forward-looking relative returns without the volatility.

AS: For the best part of 15 years, rational investors have looked to minimise their cash holdings given the drag on performance with interest rates close to zero. However, with interest rates at their highest levels in more than a decade, cash is no longer seen merely as a way to fund the purchase of other assets. Cash is back as an investible asset class.

That said, as we approach the point at which rates peak, and eventually fall, that has implications for what investors should do with their cash. It may be sensible to start thinking about extending the maturity of the paper they hold. If rates stabilise, that will still be a good environment for cash, but investors might look to allocate slightly further along the yield curve. We anticipate investor demand will expand to include additional MMF-variants capable of investing slightly longer, and ultra-short-duration bond funds.

Rates look to be far from peaking in Europe and the UK. How are you positioned in these markets?

MB: Generally, in the past year we have run short-duration positions versus what is essentially a weighted-average-maturity budget. This was expressed through a preference for short-dated fixed assets over long dated. And when it comes to taking credit risk, we have expressed that via floating-rate paper.

As we manage portfolios actively, we look to extend duration whenever we believe the market is overdoing rate hike expectations. We have done this opportunistically in sterling given the market is now pricing in terminal rates of above six per cent. We see less opportunity to do this in Europe as we believe rates may rise further than the market expects.

How have the well-publicised problems in US regional banks impacted money markets?

DA: Depositors now recognise some regional banks were riskier than they thought. This has encouraged them to shift their money into less risky, larger banks or MMFs.

The pace has slowed but the US is still witnessing large inflows into MMFs. This is especially true of funds that invest solely in short-term government or agency paper, as opposed to bank securities such as commercial paper and certificates of deposit, which obviously carry greater risk.

MB: Liquidity portfolios are dominated by financials and, as such, contribute substantially to the short-term funding of banks, so you need to follow bank fundamentals very closely.

Following the collapse of Silicon Valley Bank, a lot of cash flowed into the biggest US banks, which have consolidated their position. We like these banks and are comfortable having them on our approved list of issuers. We have always avoided regional US banks on the basis they were too lightly regulated.

The episode is a salient reminder that counterparty risk should not be disregarded. For a period, it has been seen by some investors as a secondary risk. Most people were more concerned with duration and credit spread risk. Suddenly people are asking themselves: “Am I putting my money in the right bank? Should I diversify my holdings?” This is where MMFs come into play and provide the economic benefits of a pooled investment.

How are the US government’s efforts to rebuild its cash balances, following the resolution of its fight over the debt ceiling, playing out in money markets?

DA: The US Treasury is looking to borrow around $1 trillion in short-dated bills by the end of the year, most of it by the end of September. That was initially causing anxiety, as it was unclear who would be willing to mop up such a large supply.

While MMFs were an obvious buyer, uncertainty over the outlook for interest rates was acting as a deterrent to add duration. The danger was that most funds would be content to keep overnight funds at the Federal Reserve (via the overnight Reverse Repurchase Agreement Operations, currently offering a rate of 5.05 per cent).

The supply of Treasury bills to date has been absorbed without too much fuss as the Treasury adapted its offering to MMFs’ needs by issuing shorter-dated paper. International investors have also been active buyers.

However, while conditions may have calmed down, there could be some ongoing volatility given how much supply is coming. At the margins, we would expect this to maintain upward pressure on T-bill yields, which would have a knock-on effect on the rates of interest banks need to offer investors when issuing commercial paper and certificates of deposits.

AS: US lawmakers have only agreed to suspend the debt ceiling until Jan 1, 2025, when the next president will take office. That suggests the possibility of more volatility. After all, come the end of this year, anyone considering investing in one-year government paper will be investing into the prospect of another potential debt ceiling debacle in a year’s time. 

If you are an investor who does not care about short-term volatility, you can potentially make a lot of money by trading around debt ceiling negotiation-driven volatility. But that is absolutely not a trade for MMFs.