Following the money

Steven Abrahams | December 2, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The money markets provide the financing that lets the rest of the fixed income markets spin, and the Fed has worked hard since March 2020 to ensure everything is spinning smoothly. But with higher rates and QT in full swing, a few seasoned money marketeers around a dinner table the other night highlighted a few things to watch as Fed tightening continues. One is the allocation of investor capital between cash and risk assets. And the other is bank reserves. All is well so far. But the road ahead is not entirely clear.

One eye on the allocation between cash and risk

Money markets obviously depend on having cash to funnel into a menu of eligible investments, including various forms of repurchase agreements, or repo. And repo, of course, plays a critical role in financing Street inventory and allowing smooth intermediation between buyers and sellers. But the supply of cash to the money markets—whether it sits on bank balance sheets, money market mutual funds or elsewhere—depends on how private investors allocate between cash and risk assets. And as the tradeoff between holding cash and taking risk changes, so does the cash supply.

The yield curve arguably is the clearest place that prices the tradeoff between cash and risk. As the yield curve flattens, the opportunity cost of holding cash—or, alternatively, the opportunity gained from taking risk—falls. In an inverted curve, holding cash clearly pays more in the short run. Investors should end up holding more cash as the curve flattens or inverts, and less cash as it steepens. And that pattern shows, for instance, in US mutual funds (Exhibit 1). For example:

• As the spread between 3-month LIBOR and 10-year Treasury rates went from flat or inverted in the late 1990s to steep by mid-2003, the allocation of mutual fund assets to money market funds dropped from around 75% to around 65%
• As the same spread again went from inverted in 2006 and 2007 to steep in 2009, the share of fund assets in money market funds dropped again from more than 75% to less than 65%
• And as the curve broadly flattened from 2010 and 2011 through 2019, the share of cash in money market funds steadily rose to nearly 85% of total fund assets

Exhibit 1: The yield curve influences investor allocation to cash

Note: The data shows the yield curve slope (UST 10-year – 3-month LIBOR) and the AUM of US money market mutual funds as a share of total mutual funds, including all open-ended debt and equity funds.
Source: Fed Z.1, Amherst Pierpont Securities.

My money marketeers seemed to feel comfortable that the current inversion of the yield curve would buoy the supply of cash. But they are watching for when the market senses an end to Fed tightening, starts to re-steepen the curve and starts to bid for other risks.

Another eye on QT and bank reserves

The other eye of money marketeers is on bank reserves, which are declining rapidly. They have dropped from $4.2 trillion at the end of 2021 to $3.0 trillion lately (Exhibit 2). Part of that reflects QT and limited efforts by banks so far to stop deposits from leaving the balance sheet for higher rates. Of course, compared to pre-2008, current reserves seem more than sufficient. But a lot has changed since 2008, and there is no clear formula that will let bankers or regulators know when reserve balances are sufficient or not.

Exhibit 2: Bank reserves have dropped this year by $1.2 trillion

Source: Federal Reserve, Amherst Pierpont Securities

A couple of things have my money marketeers nervous about reserves. The most obvious one is the memory of September 2019 when overnight repo rates suddenly spiked to nearly 10% despite $1.5 trillion of bank reserves. A number of things happened in that episode to suddenly increase demand for financing and simultaneously reduce the supply of reserve cash. But despite optically ample reserves, banks proved unable or unwilling to move reserve cash from the Fed into the repo markets with the speed or size needed to drive repo rates back down. The exact cause of September 2019 remains unclear, but most theories circle around the role of reserves in bank regulators’ balance sheet liquidity requirements and the frictions that creates in moving cash around. The uncertainty is unnerving, at least in a money market sort of way.

The other things that has my money marketeers nervous about reserves is recent work from the New York Fed suggesting that banks still treat reserves as scarce, despite the optical proliferation on the balance sheet. Work from the New York Fed shows that banks still view the balance between incoming and outgoing payments as a critical form of liquidity, something that many analysts expected would vanish in a world of ample reserves. Reserve balances do have an effect on this dynamic. But banks still seem more comfortable making outgoing payments if first they can draw on sufficient incoming payments. My money marketeers worry that some crisis—like pandemic, the failure of a major financial institution or market, war—would lead some banks to start holding back payments to build up liquidity. And that would set off a daisy chain of cash hoarding, depriving repo markets of cash.

A complex system

As one of my dinner friends pointed out, it’s complex. Reserves could drop and money funds could remain flush. Money funds could see outflows, but banks could learn to treat their reserves as the liquidity that policymakers intended. And then, of course, reserves could drop and banks remain guarded, funds could see outflows and some liquidity crisis could hit in just that window. Repo, in that scenario, could find itself high and dry once again. But before we could figure out the solution, we had made it through dessert. And we walk out the door into a Midtown newly dressed for the holidays.

* * *

The view in rates

OIS forward rates have repriced implied peak fed funds lower in the last few weeks from just above 5% in June to 4.90%, and the market then expects at least 50 bp of cuts by the end of 2023. That runs contrary to Fed Chair Powell’s hawkish warnings in recent weeks that the Fed will hold rates high through next year. That sets up the market for volatility next year if Powell sticks to his guns. But forecasting inflation and other elements of the economy has become extremely difficult in the aftermath of pandemic, as the Fed often acknowledges. There risk of repricing the Fed path higher.

Fed RRP balances closed Friday at $2.04 trillion, solidly below the average since June. The current and expected RRP rate still rates beats short Treasury bills into January. So falling RRP may just reflect a net falling cash supply.

Settings on 3-month LIBOR have closed Friday at 476 bp, higher by 25 bp since early November. Setting on 3-month term SOFR closed Friday at 443 bp. The spread between 3-month SOFR and LIBOR has varied with the higher cost of bank borrowing over yearend.

Further out the curve, the 2-year note closed Friday at 4.27%, reflecting the market repricing of a lower Fed path after the benign October CPI. The 10-year note closed well above fundamental fair value at 3.49%, so the higher yield has to get chalked up to a market seeing or expecting supply to overwhelm demand. It is shaping up to be a long and volatile winter for the rates market.

The Treasury yield curve has finished its most recent session with 2s10s at -78 bp. The 5s30s finished the most recent session at -10 bp. The 2s10s curve looks likely to invert by around 100 bp shortly before Fed tightening comes to an end. That is a trade for some time next year.

Breakeven 10-year inflation finished the week at 244 bp. The 10-year real rate finished the week at 105 bp, well below recent peaks around 150 bp.

The view in spreads

Volatility should continue while the Fed’s path stays in flux. But volatility should drop sharply next year as the market sees more on the path of inflation and the impact so far of Fed policy. Both MBS and credit have tightened through November. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields has dropped from more than 170 bp at the start of November to close Friday at 132 bp. Par 30-year MBS OAS has dropped from more than 60 bp to nearly 0 bp. Investment grade cash credit spreads have dropped from more than 180 bp bp over the SOFR curve to nearly 160 bp over.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates, and health stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. A recent New York Fed study argues inflation generally helps companies lift gross margins, although airlines and leisure may have an easier time passing through costs than healthcare, retail and restaurants. But in leveraged loans, a higher real cost of funds would start to eat away at highly leveraged balance sheets with weak or volatile revenues. The leveraged loan market is the bellwether to watch for broader corporate and consumer credit.