The Big Idea

Sticky demand for the front end of the yield curve

Steven Abrahams | July 27, 2024

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.

Assets that pay interest indexed to the front end of the yield curve are having their moment for now, posting some of the market’s highest yields and pulling in impressive levels of cash. But as the Fed leans into its first of a likely series of rate cuts, some fans of the front end worry investors will defect as rates fall and spreads on some of today’s favorites will widen. Falling rates may cool some of the fire for the front end, but it will likely take more than falling rates alone to put the fire out.

Front end yields compete with banks and longer points on the curve

The enthusiasm for front end yields almost surely comes from two major sources: cash leaving the lower yields offered at banks and cash leaving the lower yields available on longer points of the yield curve. Fed cuts alone look unlikely to end that enthusiasm until banks pay competitive interest rates on deposits and until the yield curve shows positive slope. Since at least 1998, both of these processes have taken years. If history is prologue, then cash should keep flowing into the front end and into floating-rate debt even as the Fed eases.

Money fund AUM makes a good bellwether

Money market funds have become one of the best bellwethers of the enthusiasm for the front end and a good place to gauge the impact of flows out of banks and from longer points on the yield curve. Money funds lately have drawn a record $6.15 trillion (Exhibit 1). As a share of GDP, money fund AUM has climbed toward 22%, levels only seen before with the start of Covid in 2020, the Global Financial Crisis in 2007-2009 and after the Internet bubble burst in 2001.

Exhibit 1: Money fund balances have reached $6.15 trillion and near 22% of GDP

Source: Bloomberg, Santander US Capital Markets.

The gap between fed funds and deposit rates links to money fund flows

Some of the cash in the front end is coming out of banks. It is hard to trace the actual flows but easy to look at how money fund AUM varies with the interest rate gap between fed funds—as a marker of money market yields—and bank deposit rates. As that gap widens, more cash should flow into money funds, pushing up fund balances as a share of GDP. As that gap narrows, cash should return to banks, and fund balances as a share of GDP should fall. That is broadly the pattern since at least 1998 (Exhibit 2). A few particulars:

Fed funds paid nearly 300 bp more than bank money market deposit accounts in mid-1998 and continued paying more until the end of 2001. Over that period, money fund AUM as a share of GDP grew from 13% to 22%. But once bank accounts started paying more than fed funds in early 2002, money fund AUM share of GDP started falling until fed funds again yielded more than bank deposits at the end of 2004.
From late 2004 to early 2008, fed funds again paid more than bank accounts, and the money fund AUM share of GDP climbed from 16% to 21%. The share later peaked in early 2009 even though bank accounts paid more than fed funds at the time, possibly reflecting investor concern about the stability of the banking system during the GFC. As banks stabilized and continued to pay deposit rates higher than fed funds, money fund AUM as a share of GDP fell.
From late 2015 through March 2020, fed fund rates again beat bank deposits, and money fund AUM as a share of GDP began to rise again, peaking in March 2020 before falling.
In mid-2022, the gap between fed funds and bank deposit rates began rising rapidly and shortly thereafter money fund AUM as a share of GDP started rising again, too

Exhibit 2: As the gap from wholesale to bank rates goes, so goes fund AUM

Source: Bloomberg, Santander US Capital Markets.

The lesson here is that a drop in fed funds is not enough to end the apparent flow of cash from banks into the money funds that dominate the front end of the yield curve. Instead, fed funds have to drop enough to nearly eliminate the gap to deposit rates before flows reverse. On average since 1998, that has taken two to three years.

The gap between fed funds and 5-year notes also links to money fund flows

Although the relationship is noisier, the difference in yields between fed funds and a longer point on the yield curve, such as the 5-year Treasury note, also affects money fund balances. Since 1998, periods where the yield on the 5-year note is lower than fed funds corresponds to a rise in money fund AUM as a share of GDP (Exhibit 3). Again, a few particulars:

From mid-1998 through early 2001, the yield curve from fed funds to 5-year notes was often inverted, and money fund AUM share of GDP generally rose.
From mid-2006 through the end of 2007, the curve gain inverted and money fund AUM as a share of GDP again rose.
In 2019, the curve inverted again and the money fund AUM share of GDP started to rise again
Since late 2022, the yield curve again has inverted, and the money fund AUM share of GDP has started to climb.

Exhibit 3: Inverted yield curves have come along with rising money fund AUM

Source: Bloomberg, Santander US Capital Markets.

The lesson here is that falling fed funds alone apparently do not end the draw of cash from longer points along the yield curve. The curve has to go from inverted to positively sloped, which since 1998 has taken roughly two years.

Sticky demand for short yields

The Fed looks highly like to begin easing later this year, and some investors worry that demand for short yield—including demand for floating-rate instruments such as ABS, CLOs and leveraged loans—will soften quickly. Rather than fed funds and other front end rates, the better predictor of demand is likely to be the spread between wholesale and bank deposit rates and the slope of the yield curve. The spread in the first case has to narrow enough to get investors to move from the yield of money funds and other floating-rate instruments into the yield and convenience of a bank account. The spread in the second case has to narrow or even disappear to get investors to move cash and take on higher interest rate exposure. In either case, it is likely to be a process that unfolds at least through 2025 as the fed returns policy rates to neutral.

* * *

The view in rates

Bullish on rates, both short and long. As of Friday, fed funds futures price in 70 bp of easing this year. The market sees more than a 100% chance of a cut in September and an 95% chance of December. The Fed has said it will need to see several months of benign inflation readings, and the May and June reports on core CPI put the Fed on the cusp. If July comes in below 0.2% month-over-month, that could set up the Fed for a September cut. The report for July comes out August 14. As the Fed begins to cut, rates on the longer end of the yield curve should come down more than anticipated by forward rates.

Other key market levels:

Fed RRP balances closed Friday at $377 billion. RRP balances have bounced between $400 billion and $500 billion since the start of March, so the last few reading come in below the range.
Setting on 3-month term SOFR closed Friday at 525 bp, down 3 bp in the last week.
Further out the curve, the 2-year note closed Friday at 4.39%, down 12 bp in the last week. The 10-year note closed at 4.21%, down 3 bp in the last week.
The Treasury yield curve closed Friday afternoon with 2s10s at -18, steeper by 9 bp in the last week. The 5s30s closed Friday at 37 bp, also steeper by 9 bp over the same period
Breakeven 10-year inflation traded Friday at 226 bp, down 4 bp in the last week. The 10-year real rate finished the week at 194 bp, unchanged now for two weeks.

The view in spreads

Implied rate volatility has come off a recent peak but rebounded lately. Credit still has momentum with a strong bid from insurers and mutual funds, the former now seeing some of the strongest premium and annuity inflows in two decades and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risky and riskless assets.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 93 bp, wider by 2 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 142 bp, tighter by 2 bp on the week. Par 30-year MBS TOAS closed Friday at 31 bp, tighter by 4 bp on the week. Both nominal and option-adjusted spreads on MBS look rich but likely to remain steady on low supply and low demand.

The view in credit

Higher interest rate should raise concerns about the credit quality of the most leveraged corporate balance sheets and commercial office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding and look relatively well protected against higher interest rates—even if Fed easing comes late this year. Healthy stocks of cash and liquid assets also allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income, although the pace of income gains has slowed this year. Consumer delinquencies show no clear signs of stress, with most metrics renormalizing back to late 2019 levels. Auto loans show rising delinquencies that have as much to do with the price of used cars as it does the consumer balance sheet. Less than 7% of investment grade debt matures in 2024, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. US banks nevertheless have a benign view of credit in syndicated loans. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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