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:
“The Securities and Exchange Commission plans to offer changes to make the most-vulnerable subset of money-market funds less susceptible to runs by their investors. The changes would include a measure called swing pricing that firms including BlackRock Inc. and Federated Hermes Inc. have warned could destroy swaths of the industry.”
In terms of global asset allocation, large holders of dollar cash now have a problem. On the one hand, the largest banks have basically told them to go away in terms of holding large amounts of cash on deposit. Corporate depositors, as a result, have migrated away from the money center banks to MMFs. This is effectively out of the frying pan and into the fire.
The MMFs now are now under a cloud because the SEC has finally decided to do the unthinkable, namely repudiate the admittedly fanciful idea of liquidity on demand at par. For example, a large portion of the counterparties using reverse repurchase agreements (RRPs) to earn income on cash are MMFs. Thus comes the question, what happens in terms of asset allocation if the SEC plan regarding MMFs is adopted? The chart below shows securities held by the Fed, total and MBS, and the level of RRPs.
Investors and financial media moguls generally need to accept that the folks at the Fed and other central banks view private markets as an inconvenience, especially when the public debt issuance of the G-30 nations has become more than a bit of a joke. Heavily indebted OECD members are still essentially given a pass when it comes to sovereign credit ratings and, in particular, the risk weights for Basel bank capital requirements.
Q: Imagine what happens to this group of heavily indebted sovereign debtors in a rising dollar rate environment? Same question for private debtors that have been effectively subsidized to the tune of hundreds of bps of default probability during QE. Now you know why European Central Bank chief Christine Lagarde is so adamant about not changing policy.
The Fed’s primary directive, namely keeping the market for Treasury debt functioning, trumps all other concerns and public policy mandates, even if that means doing permanent violence to private markets and financial institutions. If the Fed needs to go around the big banks with reverse repurchase agreements to give the MMFs and small dealers liquidity, then they will.
If the Fed needs to sequester cash inside MMFs when the markets throw a tantrum, that will happen as well. And if the Fed decides to kill the LIBOR market and replace it with SOFR, a benchmark in search of an actual market, then they will do that as well. Nobody in Congress or the markets seem to have the wit to challenge the Fed's market edicts. Even industry leaders like Jamie Dimon, CEO at JPMorgan (JPM), are strangely silent.
As the Fed pushes the private markets aside in the quest for some sort of managed stability in the US money markets, it draws nearer to the day when the market standing of the Treasury itself will be in doubt. Killing the private markets, Chairman Powell, is also an attack on the market for Treasury debt. Or put another way, when the US government is the largest issuer of debt, private investor protection becomes less of a priority.
The folks at the Fed and Treasury may believe that they are acting in the national interest, but the markets ultimately will be the judge. And remember, the "problem" with market volatility is caused by the FOMC's own actions, first and foremost QE. Looking at the deposit chart above, QE seems to have been a failure when it comes to stimulating credit creation and therefore jobs. The chart below shows total system assets vs the VIX.
Much like the levies built by the Corps of Engineers along the Mississippi River to manage floods, trying to manage the ebb and flow of dollar market liquidity by using ever greater constraints on investors only makes the bad market events worse. The money markets, large bank deposits and TBAs, and dollar swaps are all part of a larger ecosystem the the folks at the Fed seem determined to destroy. Will anyone in Congress or the financial community challenge the Fed and SEC's self-destructive actions?