Fixed Income Strategy Mixed Messages in Money Markets | March 2019 Margaret Kerins, CFA Global Head of FICC Macro Strategy Margaret.Kerins@bmo.com 312-845-2687 0
Top Seismic Shifts Impacting Money Markets Bank Fed Balance Regulatory Sheet Corporate Changes Normalization Repatriation Jan Oct Oct Nov Dec 2H: 2015 2016 2017 2017 2017 2019 Money Treasury Fed End B/S Market Issuance Runoff Reform Increases Supply and Demand Channel - Pull and push between large amounts of cash being put to work and the supply of investment alternatives in money market space 1
Federal Reserve Intervenes to Keep Control of Target Rate Fed Pays IOER to Fed Reverse Repo Fed to End B/S Possible Fed Repo regain control over Facility Mops Up Rundown Sooner to Mop up Excess effective rate Excess Cash than Expected Collateral 2
Seismic Shift #1: Bank Regulatory Reform Supplementary Leverage Ratio (SLR) - Tier 1 Capital to Total Leverage Low risk assets have the same capital charge as higher risk, higher yielding assets - Impacted broker dealers as they hold a large amount of low-risk assets - Increased the cost of balance sheet intensive products – repo - Repo balances declined dramatically - Decrease in repo available as an asset class pushed investors to increase bill - allocations Timeframe – finalized in 2014, public disclosure 2015, implementation 2018 - Source: BMO CM, Federal Reserve Bank of NY 3
Seismic Shift #1: Bank Regulatory Reform BD Repo Balance Fall due to Reform Repo Rates & Bills Yields 2,800 20 2,700 15 2,600 10 2,500 5 2,400 $Bn BP 0 2,300 -5 2,200 -10 2,100 -15 2,000 1,900 -20 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 2012 2013 2014 2015 2016 2017 2018 Feb-19 GCF Repo - Fed Funds 20D MA 3M Bills - 3M OIS 20D MA BD Repo Source: BMO CM, Federal Reserve Bank of NY, Bloomberg 4
Seismic Shift #1: Bank Regulatory Reform Liquidity Coverage Ratio (LCR) Bank High Quality Liquid Asset Demand Banks required to hold large buffers of liquid 4.00 30% assets to survive 30 days of funding stress 3.50 25% Increased demand for high quality liquid 3.00 assets (reserves & Tsy) 20% 2.50 $ trillion % 2.00 15% 1.50 10% 1.00 5% 0.50 0.00 0% 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 US Banks - HQLA (estimated) HQLA as % of Total Assets Source: BMO CM, Federal Reserve Bank of NY 5
Seismic Shift #2: Money Market Reform Floating NAV, gates & fees for non-gov’t = Shift out of prime and into Govt MMF Shift from Prime & Tax-Exempt to Gov’t MMF Holdings – Chg 2014-2018 600 3,500 3,000 400 2,500 441 200 358 245 2,000 $Bn $Bn 0 -156 1,500 -200 1,000 -511 -400 500 0 -600 2014 2015 2016 2017 2018 UST Total US Agy Total Repo Total CD/CP Muni Govt Prime Tax-Exempt Source: BMO CM, ICI 6
Implications of Money Market Reform Increased MMF demand for short Treasuries, agencies and repo = oversupply of cash seeking eligible investments – decreased repo rates and bill yields Fed RRP Facility –mopped up the excess supply of cash seeking a home 25 20 350 20 15 300 15 10 10 250 5 5 200 BP 0 $Bn BP 0 -5 150 -5 -10 100 -15 -10 -20 50 -15 -25 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 -20 0 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Jul-17 Sep-17 SOFR - Fed Funds 4wk MA 3M Bills - 3M OIS 4wk MA Domestic RRP 20D MA Zero SOFR - Fed Funds 20D MA Source: BMO CM Bloomberg 7
Money Market Reform Update Proposal to reverse some portions of money market reform Floating NAV increased borrowing costs for municipal borrowers - large decrease in tax exempt - money market funds holdings forced municipal borrowers to issue higher cost fixed rate securities Many state and local governments can only invest in stable NAV money funds, so money market - reform forced them into lower yielding US government funds Allows MMFs to elect to use the stable NAV approach instead of floating NAV to calculate their share price and to choose not to be subject to the mandatory liquidity fees Status – introduced but not enacted, bill died in the previous Congress 8
Seismic Shift #3: Heavy Treasury Issuance Net Tsy supply >$1 trillion per year Heavy Net Treasury Issuance Set to Continue – Deficits 1,600 -1,400 – Replacement Needs due to Fed B/S rundown – Basically, prior Fed purchases had financed some 1,400 -1,200 part of the prior deficits. The amount of SOMA 1,200 runoff has to be refinanced into the public markets. -1,000 Deficit (Inverted) $Bn 1,000 Heavy Coupons and Bills -800 $Bn 800 – Holds current coupon auction sizes constant, so the -600 600 funding difference is made up with net bill issuance. -400 – Therefore, auction size increases are likely in 2021 400 at current deficit projections unless Fed starts -200 buying bills. 200 0 0 2015 2016 2017 2018 2019 2020 2021 Net Cpn Issuance Net Bill Issuance Deficit Source: BMO CM, CBO, Treasury 9
Treasury Supply – Front-End Weighted Gross Issuance by Term Bucket Issuance Increase from Auction Size Change 1,600 180 160 1,400 140 1,200 120 1,000 100 $Bn $Bn 800 80 60 600 40 400 20 200 0 2 3 5 7 10 30 2yr FLT 0 2s, 3s, 5s 7s, 10s, 30s 2yr FRN TIPS Chg 2018 Chg 2019 Chg Total at Jan 2018 Size Total YE 2018 Total YE 2019 Source: BMO CM, CBO, Treasury 10
Impact of Heavy Treasury Issuance Increased bill supply pressured bill yields higher vs. fed funds 2.50 10 2.40 5 2.30 2.20 0 2.10 $Bn BP 2.00 -5 1.90 -10 1.80 1.70 -15 1.60 1.50 -20 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19 Mar-19 Bills Outstanding 3M Bills - 3M OIS 20D MA Source: BMO CM, Treasury, Bloomberg 11
Impact of Heavy Treasury Issuance Periods of crowding out from Treasury Debt Increased bill supply crowds out other money market investments Increased coupon supply increases collateral, pressuring repo rates higher Q1:18 Heavy Bill Issuance Cheapened Front-End Heavy Coupon Supply Increases Repo Rates 15 390 600 70 10 SOFR- Fed Funds BPs 500 340 60 PD Positions $Bn 5 SOFR- Fed Funds BPs 400 PD Positions $Bn 50 290 0 300 40 -5 200 240 30 100 -10 20 190 0 -15 10 -100 140 -20 -200 0 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 Jan-19 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 Jan-19 Avg PD Positions SOFR- Fed Funds Rolling 6M Bill Issuance LOIS Source: BMO CM, Treasury, Bloomberg 12
How Does Bill Supply Crowd Out? Government MMFs fill up on the highest Gov’t MMF Asset Allocation yielding assets first to the degree that they are available. 950,000 900,000 They reallocate based on relative richness 850,000 and cheapness in the marketplace within 800,000 WAM goals. $Million 750,000 Their main asset classes are UST, US Agy 700,000 and Repo. 650,000 600,000 Increases and decreases in AUM impact the 550,000 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 Jan-19 net demand for each asset class. UST US Agy Totl Repo Source: BMO CM, ICI, Bloomberg 13
How Does Supply Crowd Out Impact Relative Yields? In Feb 2018 gov’t MMF shifted into bills absorbing heavy issuance. They continued to increase bill holdings while decreasing agencies and repo as AUM declined. 3M bills moved higher than 3M OIS and repo rates moved higher than fed funds. We can also see the impact of heavy coupon supply on repo. Gov’t MMF Asset Allocation Change Relative Money Market Yields 150,000 10 100,000 5 50,000 0 $Million 0 -5 BPs -50,000 -10 -100,000 -15 -150,000 -20 -200,000 -25 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 UST US Agy Repo Total portfolio securities SOFR- Fed Funds 3M Bills - 3M OIS Source: BMO CM, ICI, Bloomberg 14
Implications Heavy Treasury Supply S Excess collateral in system increases demand for repo financing pressuring money market yields higher all else equal Record levels of Treasury supply may crowd out other money market funding sources, increasing yields across the sector (basically, everyone else funds after Treasury, so higher Treasury yields mean higher yields for all other borrowers) Fed is likely to respond with a repo facility to mop up the excess collateral 15
Seismic Shift #4: Fed Monetary & Operating Policies In 2008, the Fed created a new, risk-free earning asset when it began paying interest on excess reserves. Paying interest on excess balances was done to help to regain control over the federal funds rate. This was especially important when reserves expanded during the financial crisis placing extraordinary downward pressure on the fed funds rate. Source: BMO CM, Bloomberg 16
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