The second quarter of 2013 was marked by efforts of the Federal Reserve (Fed) to deliver some clarity about near-term monetary policy, which had the unfortunate effect of sending equity and fixed income markets into a "taper tantrum." But it was business as usual for money market funds, which continued to be driven by market technicals that kept short-term interest rates low throughout the quarter. This mindset underpinned activity in money market funds even as the Securities and Exchange Commission (SEC) revealed its proposal for additional reforms to money market funds. Market participants now have until September 17 to evaluate these proposals and offer their comments.
Tapering: There's nothing to fear but fear itself
Market participants waited, breath abated, for the statement following the Federal Open Market Committee (FOMC) two-day meeting that concluded on June 19. In it, the Fed reiterated its commitment to keep interest rates low until unemployment declines to a threshold of 6.5% and long-term inflation expectations remain anchored around 2.5%. But this wasn't the announcement markets were waiting for. Instead, there was an expectation that Fed Chairman Ben Bernanke would clarify an initial statement on May 22 regarding the possibility of the Fed tapering, or slowing down, its purchases of government securities as part of the latest round of quantitative easing.
In the press conference following the conclusion of the FOMC meeting, Chairman Bernanke eventually addressed the issue of tapering, noting that the Fed could reduce the pace of purchases through the first half of next year and end purchases midyear. Chairman Bernanke went to great lengths to emphasize that any policy shift would be data rather than date-dependent and that tapering did not equal tightening. But markets were in no mood for nuance. Following the press conference, yields on US Treasury bonds increased, equity markets declined and credit spreads widened. The 10-year US Treasury bond yield rose to 2.60% on June 25, the highest yield in nearly 22 months (Figure 1). The Fed announcement was also accompanied by a significant flow out of emerging markets.
It's a shame Bernanke's nuance fell flat for market participants, because it is this nuance — the calibration of future monetary policy — that will drive volatility in global equity and fixed income markets in the near term. Case in point: At the end of the week following Chairman Bernanke's comments, revised data revealed that the US economy grew more slowly than initially estimated during the first quarter of the year, suggesting the economy is weaker than expected. This type of data would likely contribute to postponing tapering by the Fed, and in fact, equity and fixed income markets ultimately rallied on the news.
This volatility has been kept at bay for money market funds, where interest rates on the short end of the yield curve barely budged. Yields on three-month US Treasury bills were flat (Figure 2), while the yield curve of London interbank offered rate (Libor) steepened slightly, by 0.01-0.02%.
So while money markets are not participating in the volatility, they are also not participating in the higher rates, not until the Fed actually begins to tighten — rather than just taper — monetary policy. Quarter-end market technicals compounded investor uncertainty in advance of the FOMC meeting, resulting in repo, or repurchase agreement, rates in the low single digits in June. We believe there might be some relief for repo rates as issuance begins to pick up in the third quarter. In the meantime, money market funds continue to face the challenges of falling supply, increased demand and the additional reforms as proposed by the SEC.
Comment period now open: Make your voices heard!
The SEC voted unanimously on June 5 to propose the following additional reforms to regulations governing US money market funds:
- Floating the net asset value (NAV) for institutional prime money market funds instead of using amortized cost to value portfolio securities. Government and retail money market funds would be exempt.
- Applying Standby Liquidity Fees and Redemptions Gates during times of stress, while maintaining a stable $1.00 NAV. Government funds would be exempt.
- Combining the floating NAV proposal (1) and the liquidity fees and redemption gates proposal (2) into one reform package.
- Adding more "non-structural" reform proposals to enhance disclosure requirements, improve reporting, enhance stress testing and strengthen diversification.
The proposals seek to reduce the risk of runs during times of stress, while preserving money market funds as a viable investment product. This recognition by the SEC of the central role money market funds play as a source of financing for the economy is encouraging when viewed in the broader context of the exhaustive and comprehensive study by the SEC. That said, significant issues remain, including:
- Still unresolved accounting, tax and operational issues prevent us for being able to fully evaluate the proposal to float the NAV of institutional prime money market funds. In its current form, we do not believe the floating NAV proposal helps meet the regulators' own goal of reducing the risk of runs during times of stress, while preserving money market funds as a viable investment product. We believe that the resolution of these issues will ultimately determine the utility of a floating NAV product for investors.
- A floating NAV could have the unintended consequence of actually increasing systemic risk by eliminating the key attributes that make money market funds so useful to investors, pushing them into less regulated, less transparent vehicles. In its proposal, the SEC acknowledges this possibility and tries to address it by increasing reporting requirements for private funds. However, unintended consequences and systemic risk could follow even if investors seek out more "traditional" investing alternatives such as commercial banks, which could find it difficult to accommodate such flows in light of current and upcoming capital and regulatory requirements.
- Finally, as the SEC itself points out, a floating NAV could pose huge operational challenges and costs for all stakeholders — including the fund families, investors and intermediaries offering money market funds including broker-dealers, banks and portals. These costs and challenges could fundamentally alter the business model for money market funds, pushing fund families and intermediaries out of the business of offering these products.
As we've done in past commentaries that discussed the proposed reforms, we continue to support the proposal of liquidity fees and redemption gates, as we feel it best addresses the issue of limiting heavy redemption pressures in periods of market stress, without changing the fundamental characteristics of money market funds that have made them so useful for investors and the economy.
The public comment period on the SEC proposals is now open until September 17 — and it presents investors with an opportunity to express their views. In some sections, the SEC's 698-page report contains more questions than answers, which suggests that the SEC is actively seeking feedback and input from all relevant stakeholders. There are also instances in which it appears the proposals were developed based on flawed working assumptions. This is an opportunity to strengthen the proposals by correcting such oversights and to reiterate the vital role of money market funds for businesses, nonprofits and governments across the country — both for cash management and as a crucial source of short-term financing. They are critical to our economy.
Invesco remains committed to the money market business and the pursuit of helping our clients meet their cash management needs. We will also continue to keep you informed about events as they unfold.