The market got its much-expected reduction in US rates on Wed. The prospect of further cuts is also growing, with certain pundits arguing for cuts all the way to zero.
All of which might sound like a good thing in the face of a recession — at least to your basic Keynesian. But, there are also risks to extremely low rates and two of them relate to money market funds and repo fails.
Essentially the business model of money market funds breaks down at extremely low rates. That’s because, like the vast majority of managed investments, they take a fee for investing in securities like commercial paper, repos, short-term bonds, etc. Bank of America’s Michael Cloherty uses numbers from CraneData to show the average distribution of fees, in an excellent note out today:
He says that:
At some level of short rates, the assets that money funds buy will not throw off enough cash to pay the fees and still pay investors a reasonable income stream. At that stage, we would expect investors to begin to exit money funds…
The exact rate level at which this might happen is difficult to ascertain as it depends on 1) how much room MMFs have to cut fees and 2) what minimum payout investors are willing to accept before they walk away in favour of bank deposits or whatever. There are, however, hints, according to BoA:
…the 1% target from June 2003 to June 2004 was obviously above the floor. Over that period, the 3m funds/LIBOR spread averaged 14bps. The market is currently pricing a 156bp LIBOR/OIS spread as of the December FOMC meeting. Wider spreads indicate that prime money funds will be able to handle a lower Fed funds target, although Treasury-only money funds may not.
Fine, except that as we (and BoA) have noted, the effective Fed Funds rate (i.e. the weighted average of actual negotiated rates between banks) is below the target rate. In fact it’s been averaging 59bp below target for the month of October, according to BoA, and that leads them to conclude:
… we would be comfortable that money fund assets will be stable at a 75bps funds rate, but believe the risks are excessive at 50bps.
In other words, at a target rate of 50bp (and an effective rate potentially lower) money market funds could be in very real danger of dipping below their $1 net asset value — breaking the buck. That would have major implications for the shadow banking system.
Recall for instance, the bleak month of September, when Reserve Primary’s buck-breaking (the second MMF to ever do so), started a run on commercial paper - a sector which is only just beginning to show signs of recovery - and only after the US bought $146bn of it.
Of course, the impact of an MMF breaking the buck would now be significantly less than before.
After Reserve Primary, the US Treasury announced it would temporarily insure MMF holdings, much like FDIC and bank deposits. Now, if an MMF breaks the buck, FDIC will restore its NAV back to $1 (with the caveat that only assets invested in the fund before Sept. 19 are covered).
The irony is that by reducing rates to save the economy as a whole, the US may be risking further bailouts of money market funds and tightened liquidity. It’s another great example of the tightrope act that is public finance.
Repo fails, incidentally, are also at risk of increasing in an low-rate environment, but that may be the subject of another, later, post…
Related link:
Welcome to the roach motel - FT Alphaville
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