Steve Chiavarone: Hello, and welcome again to the Hear and Now Podcast with Federated Hermes. I'm Steve Chiavarone, Portfolio Manager and Equity Strategist. And today I'm joined via phone by Debbie Cunningham, Chief Investment Officer of Global Liquidity Markets. We're going to discuss the impact COVID-19 has had on the liquidity market, and Debbie's outlook for the remainder of 2020. Debbie, welcome to the podcast.
Debbie Cunningham: Thanks Steve. Glad to be here.
Steve: Let's jump right in here. Debbie, how have liquidity markets fared since the COVID-19 related volatility began?
Debbie: Well, the liquidity markets really like most other markets sectors, were definitely challenged but functional throughout the last six to eight weeks. Secondary market liquidity became strained in mid-March and this was really evidenced by the wider bid-ask spreads that we saw in all segments of our market at that point. And as we had daily uncertainty about the pandemic itself unfolding, the Fed took note of this. They were concerned about this lack of liquidity or lower liquidity and the wider bid-ask spreads, and they really added to that liquidity for all short term high quality markets.
Debbie: They started in the government markets. They have buying programs that they announced for Treasury securities and agency mortgage-backed securities. And they did this both directly in the marketplace through the securities themselves, as well as through the repo markets. After that they moved to the prime sector and high quality short term markets, and they created the MMLF, the Money Market Liquidity Facility. This was in conjunction with adding secondary market liquidity to the commercial paper market, the asset-backed commercial paper market, and then even broader to the CD markets.
Debbie: The next facility that came about was the Primary Dealer Credit Facility. That was at around the same time as the MMLF, and this was to assist in secondary market liquidity for broader markets, so it included those commercial paper, ABCP, CD types of markets, but also broader markets beyond money markets. And not to exclude any sector, the Fed then broadened support by the MMLF by including the tax-free sector and adding short-term, high quality muni securities and variable-rate demand notes to the acceptable collateral list that could be taken into this facility.
Debbie: Throughout this timeframe, the market makers, the issuers, the investors in the marketplace, gained confidence. And they gained confidence because that bid-ask spread narrowed and the constrained liquidity became less so. This became so much the case that when the first quarter of 2020 ended, money market funds had actually taken in net flows of 689 billion. This was a record for the industry, so it's had large intakes before but never this much. Since then the inflows have slowed, but they have also continued. And as opposed to the first quarter when asset gains in the industry were concentrated and really pretty much just the government sector, those gains have become more diversified. They include inflows in both the prime and the municipal sectors as well at this point.
Debbie: From a rate perspective, the government money market yield curve is positive on the probably zero to 15 basis point line right now, and it's off basically what we're single digit low levels in the end of March. Prime spreads over government securities have come down. They were at mid-March lofty levels of greater than 150 basis points, and are now more normalized right around 45 to 50 basis points. Tax-free yields, which very much outpaced even taxable yields on a before-tax basis in the later part of March and early April, have resumed their more normal levels as well. And yet still represent good after-tax value, which is why effectively all three of these sectors are continuing to grow.
Steve: It's interesting because from a macro perspective, and you're a senior member of the Federated Hermes Macro Committee, the unprecedented actions by the Fed, and to a lesser extent the federal government, but certainly both entities, really did solve some of the liquidity and credit market issues. Taking the worst-case scenario off the table and allowing markets to return to some sense of normalcy, despite the fact that we have this severe economic impact that's still ongoing from the crisis.
Steve: So would you say that your markets are mostly back to normal, all the way back to normal, or still have some ways to go?
Debbie: I think they're mostly back to normal and quite honestly, I give the Fed an A grade on their performance over the course of the last two months. They were quick to respond. They were responsive with their responses. So they initially came out with the MMLF just facilitating commercial paper and ABCP. They quickly added CDs. They then added short-term, high quality muni securities.
Debbie: So they've been responsive to needs of the marketplace as they crop up, and they've done it efficiently and effectively. Which is why my answer to that question, Steve, is most of the way back to normal. Certainly we're not down to what I call the normal 20 to 30 basis points spread in the short-term credit markets versus the governments, but I don't think we will or should be back at those levels because of the continuing concerns about what impact this is going to have on the credit markets and the economy going forward.
Debbie: Although it's not yet officially confirmed, the US as well as the world, everybody knows, is in a recession. First quarter GDP confirmed pushed into negative territory during the month of March. January and February were fine. March still pushed the whole quarter into negative territory. And I think the real question now is, how long does this pandemic-induced recession last? And that's why credit spreads will not go back to absolute normal lower levels. They're going to have some spreads still say in them.
Steve: Well, and let's stick with that point, because we are in the middle of a recession very likely. There continues to be some volatility, at least economic volatility. And so even the sharp disruptions that occurred in your space, then the normalization that's occurred on a relatively quick basis, what's your outlook for the liquidity market in the coming months as we go through this recession, and then the eventual recovery?
Debbie: Well, the Federated Hermes base case scenario is for a U-shaped recovery. It's not going to be a L-shape, not going to be a V-shape. We think that the more likely scenario is a U-shaped recovery. And what this means for the liquidity markets is a period of time where we're going to spend in that zero-rate environment again, but with important differences from the last time that we encountered those zero rates.
Debbie: One difference is that with a U-shaped recovery we can expect the Fed to get off that zero-bound within a year or two. Certainly not like the close to a decade that we saw in the 2008 to 2016 timeframe. A second difference is that our expectation for spreads, as I mentioned before, is to remain a little bit wider. And this is again, based on longer lingering concerns about the virus and about the further implications from the standpoint of that recovery and the credit markets.
Debbie: And I think the FOMC (Federal Open Market Committee) from their part has already begun to think about and execute their withdrawal strategy from the market. They've reduced their daily and weekly buying and operations in the Treasury and repo markets. So their term operations, their daily operations and their QE (quarter end) types of buying have all been reduced. And this is in addition to what has become an increasingly larger amount of supply that is coming to the market to help fund Treasury through their Main Street types of lending programs.
Debbie: So you've got the Fed stepping back and not needing to buy as much from a supply perspective to keep the markets functioning normally, at the same time as that supply in fact is building. So that also lend credence to the fact that the short-term markets are functioning at what they believe to be acceptable levels. So I think as industries resume and their supply chains start to reconnect, this will require additional funding. And that will also be additive to supply, which I think will keep those spreads in the marketplace a little bit wider, yet with still market efficiency.
Steve: And let's put all this together. So as you know, within the Federated Hermes PRISM Asset Allocation Program, we are just slightly overweight to cash as an asset class. How do you think about money markets from an asset allocation perspective within an overall portfolio? How should investors be thinking about this space in their overall portfolio?
Debbie: It's definitely the most conservative aspect of their asset allocation, but it's one that is in constant use. And the reason that it's continuously used, whether it's over-allocated, under-allocated or at a midpoint, is because of the features of safety, liquidity and stability. From a safety perspective, the investments in a money market fund represent high quality, minimal credit risk issuers. They are diversified, and their quantitative and qualitative health in the liquidity markets and in the issuers that we use, is immense. For liquidity products, the qualitative ESG (Environmental, Social, Governance) assessments that are now being used as part of the credit rating process, I think have been additive to the continuous monitoring of the high quality nature of these issuers. So safety is just at the top of the priority chain.
Debbie: From a liquidity perspective, investors in money market funds have been and will continue to be able to invest or withdraw their cash in these products on a T plus zero basis daily. So if you need more cash to fund redemptions in your other products, the liquidity product helps buffer that. If you get cash from a throw off of your other allocations, you could invest it in your money market products.
Debbie: The published information that we provide also daily and weekly on our liquid assets and the products that are in this space, help affirm to our customers the commitment to liquidity in this space. And I think that that's well-received. When chaotic markets follow global panics like we've had, the money markets really provide a safe haven. We saw that, 689 billion into the product investments in the first quarter. Their flight to quality investments, and that includes both institutional and retail investors.
Debbie: And then finally when you look at it from a price and a yield perspective, liquidity funds, money market funds, provide investors with a stable price and a market yield that's reflecting very low risk of these very high quality markets. And although yields are low, given the recent Fed moves, investors should be confident that they reflect current monetary policy, which is based on the economy, which will adjust us upwards as the world exits the effects of the lockdown and the coronavirus and normalizing in the economy actually takes hold.
Steve: And I would just reaffirm maybe one or two points there. I think the reason why we're overweight within the PRISM asset allocation framework is, in markets that are highly volatile, having liquid assets to be able to put to work quickly is important. In an environment with great uncertainty, liquidity certainly is valued and is an important part of a portfolio.
Steve: So Debbie, I want to thank you for your comments today and your insights. I'd also like to provide a thank you to our listeners. We look forward to joining you all again on the Federated Hermes Hear and Now Podcast. And if you enjoyed this podcast, we invite you to subscribe to the Federated Hermes channel to get every Hear and Now episode, plus our other series Amplified and Fundamentals, for a global perspective on the issues, challenges and trends shaping the investment landscape. Thank you.
Disclosure: Views are as of May 5, 2020, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. Past performance is no guarantee of future results. You could lose money by investing in money market funds. Although some money market funds seek to preserve the value of your investment at 1.00 USD per share, they cannot guarantee they will do so. An investment in money market funds is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Federated Investment Management Company 20-10064 (5/20)