Uncertainty dominated financial markets during the third quarter of 2012 as the US neared Election Day, and continued to prevail even after the elections as attention quickly shifted to the Fiscal Cliff. We look at these issues and discuss our outlook for, and drivers of, short-term rates as well as the recent recommendations for additional money market reforms proposed by the Financial Stability Oversight Council (FSOC).
The impact of the looming "Fiscal Cliff"
Uncertainty prevailed after the November 6 elections, which broadly resulted in a status quo in the White House and Congress. While some uncertainty was removed, for example with regard to the direction of monetary policy, significant concern remains, mainly regarding the so-called "Fiscal Cliff."
What is the "Fiscal Cliff"? The Fiscal Cliff represents $600-$650 billion in economic contraction, of which two-thirds includes expiring tax cuts (e.g., payroll tax holiday) and one-third consists of spending cuts (e.g., extended unemployment benefits), that is scheduled to become effective in the beginning of 2013.
Scenarios for resolution of the "Fiscal Cliff"
- "Going off the Cliff" (No agreement) – If the economy goes off the Fiscal Cliff, the impact could be a drag of approximately 4% of gross domestic product (GDP). The status quo results of the elections have increased the chance for this scenario.
- "Grand plan" – With a lame-duck session of Congress in place, we do not believe that there is enough time between now and the end of the year – the House has only 16 days and the Senate has only 32 days in which they are in session until the end of the year - for a grand plan or fundamental resolution.
- "Kicking the Can" – Given the timeline, a temporary fix – what we're calling a good faith down payment – could involve some of the less controversial measures, such as the Alternative Minimum Tax or subsidized Medicare payments. This could give Congress time to work on a more comprehensive solution next year.
Looking ahead to the debt ceiling – On October 31, the US Department of the Treasury reiterated that it expects to reach the debt ceiling ($16.4 trillion) at the end of this year, although extraordinary measures can be put into place to postpone that deadline until early 2013.
- The day after the elections Fitch Ratings and Moody's Investors Service stated that a failure to reach an agreement with the fiscal cliff and the debt ceiling would likely trigger a rating downgrade. Fitch and Moody's currently have the US sovereign rating at AAA with a negative1 outlook.
- Fitch and Moody's have been very consistent in their messaging over the last six months that the debt limit needs to be addressed and a credible deficit reduction plan needs to be established to avoid a US sovereign debt rating downgrade in 2013. A last-minute agreement to raise the debt ceiling and regular threats of payment default would most likely place the AAA sovereign rating of the US in doubt.1
Outlook for short-term rates: Going lower
While repurchase agreement (repo) interest rates have been elevated year-to-date, we believe the following factors could contribute to lower rates as we head into year-end and early 2013.
Repo rates have been elevated since the beginning of the year, largely because of Operation Twist. In 2011, the average Treasury repo rate was 5 basis points (bps). Once the Federal Reserve (Fed) began Operation Twist, dealer balance sheets began to increase as the Fed sold short-term securities to buy long-term bonds. Dealers have had to finance the short-term securities on their balance sheets until such time as they could sell them, leading to higher repo rates. However, we believe the sunset of Operation Twist at the end of the year will put downward pressure on repo rates.
The third round of quantitative easing (QE3) will likely put additional downward pressure on interest rates. This round of QE consists of a $40 billion purchase of mortgage backed securities (MBS) each month. The Fed has not announced a hard end-date for QE3, instead noting that the outlook for the job market would need to improve substantially. With unemployment at 7.9%, we believe this round of QE will remain with us for some time.
Unlimited Federal Deposit Insurance Corporation (FDIC) insurance is scheduled to expire at the end of 2012, meaning that deposits at commercial banks will be insured up to $250,000.
- We believe there's a low probability of extending unlimited insurance because Congress would have to vote to extend it and it doesn't appear they have time to do so with everything else on their agenda – including the afore mentioned fiscal cliff. The FDIC website (www.fdic.gov)* has already put out guidance for banks to start warning their clients that unlimited insurance is ending.
- Impact on short term rates: While we believe there may be some movement of deposits out of commercial banks, we do not know the scope or the speed of such withdrawals. However, with non-interest bearing checking deposit balances increasing by $550 billion since the program started even a small movement (i.e., a few percentage points) out of deposits, which would then be invested directly into short-term markets could put additional downward pressure on interest rates, particularly Treasuries.
Money market reform
The Financial Stability Oversight Council (FSOC) voted unanimously on Tuesday, November 13 to advance three recommendations for reform of the money market fund industry for public comment.
What are the recommendations?
- Floating Net Asset Value (NAV). Require money market funds (MMFs) to have a floating NAV by removing the special exemption that currently allows MMFs to utilize amortized cost accounting and/or penny rounding to maintain a stable NAV.
- NAV Buffer (up to 1%) and "Minimum Balance at Risk." MMFs would retain their stable NAV but be required to have an NAV buffer of up to 1% of assets to absorb day-to-day fluctuations in the value of the funds' portfolio securities. The NAV buffer would be paired with a requirement that 3% of a shareholder's highest account value a shareholder's highest account value in excess of $100,000 during the previous 30 days — a minimum balance at risk (MBR) – be made available for redemption on a 30-day basis.
- NAV Buffer (up to 3%) and Other Measures. MMFs would retain their stable NAV but be required to have a risk-based NAV buffer of 3% to provide explicit loss-absorption capacity that could be combined with other measures to enhance the effectiveness of the buffer and potentially increase the resiliency of MMFs (e.g., more stringent investment diversification requirements, increased minimum liquidity levels, and more robust disclosure requirements).
What is a possible timeline for the reforms? While we don't know what the actual timeline will be, since there is a lot of uncertainty regarding the process, below is an estimated best guess:
- By early February 2013 – Comments due to FSOC within 60 days of the proposal appearing in the Federal Register (Nov. 19, 2012). All comments will be made public.
- By early May 2013 – If FSOC recommends one of the proposals, Securities and Exchange Commission (SEC) has 90 days to adopt or explain why it cannot.
- Late 2013 – early 2014 – Assuming the SEC adopts the FSOC proposals, it would follow its normal rulemaking and comment period schedule. The 2010 Reform period took approximately four months and this is with the industry in agreement of the proposals. We estimate that this would be late 2013 or early 2014.
- Implementation of any of the proposals would be a multi-year process.
- Alternative one (Floating NAV), would include a five-year phase out for Stable NAV funds.
- Alternative two (Buffer + MBR), buffer would need to be in place within two years (with intermediate milestones)
- Alternative three (Buffer + "Other"), one-third of the buffer would need to be in place within two years. The remaining transition period is unspecified but would likely be multi-year.
What is Invesco's position?
- The FSOC is proposing to send back to the SEC the very same concepts that a majority of SEC's members declined to issue for public comment in August.
- These concepts have already been the subject of extensive analysis and commentary.
- We are open to proposed changes that preserve the key characteristics of money market funds that have made them so valuable to investors, issuers and the economy.
- Additionally, any changes must preserve a competitive marketplace of funds and fund sponsors, thereby giving investors a choice.
- The proposals should not increase the risks to the financial system by concentrating assets in a few large institutions and/or driving assets into alternative products that are far less regulated and transparent.
Fund Positioning
Invesco's money market funds have undergone a number of shifts over the last six months in response both to technical and fundamental market conditions, including for example taking advantage of higher repo rates. As we head into year-end, we will focus on finding attractive investment opportunities that take us past the New Year in order to minimize the impact of any supply issues late in the year while seeking to provide the liquidity necessary to satisfy year-end redemptions.
