PMC Weekly Review - October 14, 2016

A Macro View: Money Market Reform – Impact and Expectations

Money markets have long been viewed as a safe and boring afterthought in the context of a diversified portfolio, but things may become a little more interesting on Friday. October 14th marks the deadline for compliance with the SEC’s long-awaited reforms in the regulation of money market portfolios. These reforms are aimed at fostering financial market stability and preventing a “break the buck” scenario in the event of a financial crisis like 2008. Much stricter requirements will be enforced for all non-government money market portfolios, most notably prime and municipal money markets. These measures include a floating net asset value (NAV) and the fund manager’s ability to impose liquidity fees or the outright suspensions of redemptions.

The reforms already have resulted in a $1 trillion exodus from prime funds, and many asset management firms have converted their prime money market portfolios into government-only funds in an effort to meet client demand and avoid the floating NAV. These measures also have had visible impacts on financial markets. Three-month London Interbank Borrowing Rate (LIBOR) has been trending upward for months, reaching a post-crisis high of 87 basis points, as banks have been forced to increase their short-term offer rates to attract lenders. This, of course, has consequences for floating-rate securities, such as bank loans, which use LIBOR as a reference rate. US municipalities also face a jump in short-term borrowing costs due to a similar rise in the Securities Industry and Financial Market Association (SIFMA) rate, the baseline for short-term municipal debt instruments, such as variable-rate demand notes.

Potential longer-term impacts of these reforms remain to be seen. The increase in government-only mandates will continue to drive up demand for T-Bills and other short-dated government issued securities. Of course, the supply of these securities is dependent on fiscal policy and the budget deficit, and could eventually be affected by Congress’ willingness (or lack thereof), to raise the debt ceiling. These reforms also may limit the Fed’s ability to control short-term interest rates, as stronger demand for government securities places a cap on short-term Treasury yields and exerts pressure on the Fed’s reverse repo facility. At the same time, demand for short-dated corporate paper has declined, which likely will continue to have an impact on companies’ borrowing costs to meet their short-term financing needs. Jerome Schneider, head of short-term portfolio management at PIMCO, emphasized the spike in LIBOR is “not just the market’s reaction to a piece of data, but a structural reform that changes the way investors allocate their cash”, meaning higher LIBOR rates are likely here to stay.

The one variable that could reverse the current trend toward government money markets is higher interest rates—if the yield on prime money markets reaches a point where it begins to draw investors away from government-only portfolios. Although the SEC’s good intentions aim to protect investors and reduce the potential for contagion in the event of a financial market crisis, it is unclear whether these money market reforms will ultimately be beneficial, or become an impediment to efficient capital markets.

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