The Big Idea
Cash piles up, but the Big Risk Bid awaits
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 record $6.3 trillion in cash now sitting in money market funds will likely start flowing into risk assets one day, extending duration, taking spread risk or both and putting its mark on asset performance. But that day has not come yet, even with the Fed leaning into a run of rate cuts. In fact, the opposite is happening. With cash yielding significantly more than most risk assets, money fund balances lately are rising at their fastest pace of the year. But when that yield gap eventually narrows, watch out for the Big Risk Bid.
A rising yield advantage for cash
The yield advantage of cash has increased substantially since May as fed funds and other cash yields have held their ground and longer US yields have dropped in anticipation of Fed cuts. Fed funds yielded around 40 bp more than 2-year Treasury notes in May, for instance, and around 60 bp more than 2-year notes in late June (Exhibit 1). But as the frequency and magnitude of expected cuts has run up in July and August, the yield advantage of cash has multiplied. Fed funds in recent sessions have yielded 164 bp more than 2-year notes. Cash has become the highest yielding asset in the debt markets by a widening margin.
Exhibit 1: The yield advantage in cash has increased lately
Source: Bloomberg, Santander US Capital Markets
The yield advantage in cash has helped feed money market funds. For the four weeks ending August 28, money market funds picked up $128 billion in cash, the fastest 4-week pace of the year (Exhibit 2).
Exhibit 1: Money fund AUM accelerated in August
Source: Bloomberg, Santander US Capital Markets
Money funds look likely to continue picking up AUM—although likely at a slower pace—until the yield difference between cash and other risk assets drops significantly. At least that’s the lesson of at least the last 25 years. With the Fed likely to ease by an expected 75 bp this year and a cumulative 175 bp by the end of 2025, according to Santander economists, the yield advantage of cash looks set to stay in place until late 2025.
Cash should begin allocating more to risk assets on the margin as the cash yield advantage shrinks and then reallocating outright from cash assets into risk assets once it disappears. Only when the yield advantage disappears should money funds begin losing AUM, at least as a share of GDP. Where the cash goes will depend on what looks like an acceptable substitute. Investors that want higher yield without spread risk will likely extend along the Treasury curve. Investors that want higher yield and can take spread risk should move across a wide set of possibilities including corporate and structured credit and MBS.
Since cash first picked up a noticeable yield advantage in March 2023, money funds have picked up a cumulative $1.25 trillion in cash. Of course, that rising cash balance reflects the continued rise in GDP and the spring 2023 concerns about the collapse of Silicon Valley Bank, too. But the movement of even a modest amount of that cash into other assets should have a meaningful impact on yields and spreads.
It’s early, but the Fed’s easing cycle should put a Big Risk Bid in motion. One way to position for this would be to hold a barbell of cash and longer risk assets such as 3- or 5- or 10-year corporate or structured credit. The cash should enhance returns until the cash yield advantage disappears and the risk leg should tighten in spread as marginal cash allocates into it through the Fed cycle and existing cash starts to jump into the risk game when the advantage disappears. The barbell should beat spread assets of comparable duration.
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The view in rates
Still modestly bullish on rates, both short and long. As of Friday, fed funds futures priced in 116 bp of easing this year—up 20 bp from three weeks ago. This follows Powell’s Jackson Hole speech and Friday’s soft August payrolls report. The market now prices cuts in September, November and December and anticipates 50 bp at one or more of those FOMC meetings. That is probably faster than the Fed will start out. But markedly weak data could accelerate easing in 2025. As fed funds head toward 3%, the front end of the yield curve should lead rates lower with the 10-year and longer end of the curve moving much more slowly.
Other key market levels:
- Fed RRP balances closed Friday at $299 billion. RRP balances bounced between $400 billion and $500 billion from the start of March until the end of July. Initially, better yields in T-bills drew cash out of RRP, but those yields have dropped in anticipation of Fed cuts. Now better yields in Treasury and MBS repo are the draw.
- Setting on 3-month term SOFR closed Friday at 494 bp, down 19 bp in the last three weeks as Fed cuts get closer and the possibility of a 50 bp cuts improves.
- Further out the curve, the 2-year note closed Friday at 3.66%, down 40 bp in the last three weeks. The 10-year note closed at 3.72%, down 17 bp in the last three weeks.
- The Treasury yield curve closed Friday afternoon with 2s10s at 6 bp, steeper by 23 bp in the last three weeks and ending a 2s10s inversion that started in July 2022. The 5s30s closed Friday at 53 bp, steeper by 15 bp over the same period
- Breakeven 10-year inflation traded Friday at 203 bp, down 5 bp in the last three weeks. The 10-year real rate finished the week at 168 bp, down 13 bp over the last three weeks.
The view in spreads
Implied volatility has rebounded to roughly the average of the last year, fed by big daily moves in rates. That has put pressure on spreads. Credit still has support from 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. Nevertheless, high rate and equity volatility have pushed credit and nominal MBS spreads wider.
The Bloomberg US investment grade corporate bond index OAS closed Friday at 97 bp, wider by 3 bp in the last three week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 133 bp, tighter by 7 bp in the last three weeks. Par 30-year MBS TOAS closed Friday at 32 bp, tighter by 1 bp over the last three weeks. Low supply is helping keep MBS spreads relatively tight.
The view in credit
The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding so falling rates have limited immediate effect. Rising unemployment should put pressure on consumers, but high levels of home equity and investment appreciation should buffer the stress. Other parts of the market funded with floating debt continue to show weakness. 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.
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