Liquidity investors have lots to consider, but nothing as pressing as it might seem.
With concern about inflation on many minds, Federal Reserve officials took countless questions last month about when they will scale back accommodative policy. To Chair Powell, it probably sounded like kids in the back seat of a car on a trip— “Are we there yet?” —to which he had to repeat, “Not yet!”
Policymakers do not think that the backup in long rates means inflation is even on the tarmac, let alone ready to take off. In testimony on Capitol Hill, Powell said the surge in the 10-year Treasury yield had more to do with the progress of vaccinations and expectations of growth. The Fed is not going to change policy for “some time,” the same indefinite period in which it will let core PCE exceed 2%. Projections from the March Federal Open Market Committee meeting showed a slight shift earlier to a 2022 timeframe, but that’s it. The news from the meeting that disappointed cash managers was that the committee didn’t lift its rates on overnight lending (reverse repo and IOER).
The rise in the 10-year yield so dominated the financial press, you’d think the $1.9 trillion American Rescue Plan didn’t pass. So far, most of the dispersed dollars have gone to personal stimulus checks. The tax-free space should be boosted as the Plan provides substantial direct aid to state and local governments. We still expect that the Treasury will have to issue enough bills when funding it to reduce pressures on short rates somewhat. But the wild card from a supply perspective is that the Fed let the temporary exemption of the Supplementary Leverage Ratio (SLR) expire. Part of the regulations that emerged from the global financial crisis, the SLR essentially forces the biggest U.S. banks to hold more reserves to better counter market disruptions. But the rule hurt liquidity during the depth of the pandemic crisis and the Fed suspended it, allowing banks to exclude Treasuries when calculating the ratio.
It will be intriguing how this development plays out. Banks are going to have to hold more capital if they keep their balance sheets the same (though most top banks already have excess capital, so it likely would be marginal). Will they sell securities? Will they reduce their bids in Treasury auctions? Both of these actions could increase supply in the market. Or will they downsize their total balance sheets and begin shedding excess deposits in the process? The former could increase supply and potentially lift rates slightly. The latter is less clear, but certainly could lead to the opposite if capital flows into the money markets. There are plenty of variables, and things will get interesting.
Last month also saw the Fed close its three emergency programs targeted at the broad money markets in March of 2020: the Money Market Mutual Fund Liquidity Facility, Primary Dealer Credit Facility and Commercial Paper Funding Facility. This makes sense as they haven’t been used much for nearly a year. Here’s my turn for a refrain. Liquidity was constrained in the broad money markets, yet regulators of all types keep queuing to put the blame on money market funds. There are many variables here, too. We continue to work with industry leaders and associations to respond, with expectation that many of the proposals will be unnecessary, and that perhaps some positive changes might arise.
Industry-wide, the government money market space experienced inflows in March, while prime and tax-free faced modest outflows. We kept the weighted average maturities of our money funds in target ranges of 35-45 days for government and 40-50 days for prime and municipal.