Updated: Dec 17, 2021
First the Fed and Bank of England colluded to destroy LIBOR for no real reason save regulatory pique. Then the Fed and Group of Thirty suggested centralized clearing of Treasury debt, a very bad idea. Now, the Fed and SEC want to lobotomize mutual Money Market Funds (MMFs), this just as banks are pushing corporate cash out of the house.
In this issue of The Institutional Risk Analyst, we update our readers on a question we first addressed this past May, namely the impending death of MMFs as cash equivalents. Is there anywhere safe for large investors to stash short-term dollar liquidity as the Fed nationalizes the private money markets?
In our widely read comment, “Fed Prepares to Go Direct with Liquidity,” we talked about the plans of the Federal Reserve Board and the Securities and Exchange Commission to suspend redemptions by MMFs during times of market stress.
Now the Wall Street Journal confirms our earlier report, which comes just as corporate investors have been migrating out of bank deposits into MMFs. With the FOMC now intent upon shrinking bank balance sheets by ending quantitative easing or "QE," cash investors are trapped.
As we take a look at the state of the US money markets as year-end 2021 comes into view, we cannot help but be amazed by the market’s inaction as the Fed and SEC prepare to make a substantial change in US market structure. If the banks have closed the window for large deposits and MMFs are no longer safe as repositories of cash, where is a corporate CFO or Treasurer going to park next week’s payroll?
This fundamental question is unlikely to be answered in the near-term, meaning that cash is going to seek out alternatives. The process of shifting around trillions of dollars in liquidity with the sudden end of QE is unlikely to be helpful in the days and weeks ahead.
The market narrative is fixated on COVID as the reason for the equity market selloff, but the real reason is the changes underway at the Fed with the end of quantitative easing. We noted last month in “As the Fed Ends QE, Stocks and Crypto Will Retreat” that QE was the fuel for stock and home price appreciation. The proverbial F-16 has reached its operational ceiling, meaning that everything from meme stocks to crypto tokens are in for a correction. The chart below shows total issuance for key debt markets from SIFMA through November.
Notice that mortgage issuance is falling rapidly along with corporate debt sales. In our most recent banking industry survey, we focused on the fact that the return on earning assets for banks rebounded in Q3 2021, this in large part due to a shift in asset returns for largest banks. But the change also reflects the forcible expatriation of large deposits from banks to short-term funds. Dick Bove notes that mounting liquidity at banks ultimately forced a change from banks to MMFs:
"These deposits created a problem for the banks because loan volume was plummeting and, therefore, the deposits were not being loaned to the private sector. Instead, the banks were forced to put the money into deposits at the Federal Reserve and Treasuries… The banks have taken a number of steps to stop the deposit inflow such as asking large corporations to put their money into institutional money market mutual funds (I-MMMFs) and not the banks.”
Markets now expect that the FOMC is going to end purchases of MBS by the end of March, a good development because of the rapid decline in volumes that is expected in the new issue market and the brisk bid for loans and servicing. The mortgage market does not need further assistance from the FOMC with conventional servicing assets going for multiples of annual cash flow of 5-6x, near the peak levels of several years ago and the 1990s.
With the volumes in the MBS markets headed south and Washington’s Build Back Better legislation lost in the political fog for now, there may be a shortage of paper relative to the past several years. Indeed, if we go back to a core thesis that two factors, namely the availability of 1) cash and 2) risk free collateral together comprise the liquidity of US markets, then tightening is already baked into the economic pie beyond simply ending QE. Look for the bank deposit series in the chart above to come down sharply in coming months.
Any mismanagement of the tightening process by the FOMC could see the market repeat past liquidity tantrums in 2020 and December 2018, with potentially severe political consequences for Fed Chairman Jerome Powell and the Fed as an organization. But the added fly in the proverbial ointment is the prospective changes in the workings of MMFs, a badly considered structural alteration to the US money markets that could have dire consequences for the dollar and the domestic liquidity situation for Treasury debt. The WSJ reports: