Money Market Portfolio Manager Garrett Strum discusses the recent actions taken by the U.S. Federal Reserve to improve liquidity in money markets.
- Money market funds have struggled with a lack of liquidity in short-term commercial paper (CP) and certificates of deposit (CDs), making it more difficult for companies to issue CP and CDs to raise short-term cash.
- The U.S. Federal Reserve (Fed) has responded with a number of programs aiming to boost liquidity, including the Primary Dealer Credit Facility, the Commercial Paper Funding Facility, and the Money Market Liquidity Facility.
- We are encouraged by the recent actions from the Fed as they demonstrate that they’re focused on bringing liquidity to asset classes showing distress, though it will take time to see how the money markets respond to the measures and whether further programs will be needed.
With target interest rates now between zero and 25 basis points, the U.S. Federal Reserve (Fed) has turned its attention to address illiquidity in credit markets, including the short-term credit markets, which include the money markets. Even institutional prime money market funds have struggled with the lack of liquidity in short-term commercial paper (CP) and certificates of deposit (CDs), where it has become difficult for funds to sell these instruments. The lack of liquidity is less a result of credit concerns (as it was in 2008, during the Global Financial Crisis), but rather more of a mechanical problem caused by high levels of inventory at broker-dealers: The inability to easily liquidate a holding makes fund managers more reluctant to purchase securities, which in turn makes it more difficult for the issuers of the securities to raise cash.
Money market funds, generally speaking, are seeing their assets under management rise as investors look to reallocate into lower risk investments. This is true even within money market funds as some investors have moved from Prime credit funds into Government and Treasury funds. But portfolio managers look ahead, and when they consider the possibility that the flows into their funds could quickly reverse, they could rapidly become forced sellers into what has become an illiquid market. Given that money market funds seek to provide minimal or no principal volatility, depending on the investor base, while also maintaining a large balance of liquidity, being forced to sell at below-fair value or not be able to sell at all can create strain. As such, many money market funds are choosing to keep the tenor of their investments short, sometimes as short as one day via overnight repurchase agreements (repos). The resulting lack of demand for longer tenor investments has caused spreads in the commercial paper market to backup rapidly and significantly.
The Federal Reserve Responds
To address these issues, and the possibility that a shortness of liquidity raises solvency concerns, the Federal Reserve has launched an array of liquidity-boosting programs. The Primary Dealer Credit Facility (PDCF), which allows broker-dealers to pledge collateral for short-term loans, has been used before and potentially provides an avenue for broker-dealers to reduce their inventory and use the cash for improved market-making. Importantly, dealers can offer investment-grade commercial paper as collateral, in addition to a broad range of other investment-grade instruments including municipal bonds, corporate bonds.
The Fed is also targeting the commercial paper issuers directly by relaunching the Commercial Paper Funding Facility (CPFF), which allows the Fed to purchase from them without a broker-dealer involved. This will help reduce the supply of commercial paper coming to the market. Finally, the Fed has introduced the Money Market Liquidity Facility (MMLF), which is a slight variation on a Global Financial Crisis program called the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF). The program has been expanded to include unsecured top tier rated commercial paper issued by U.S. issuers, among other securities such as U.S. Treasuries, Agencies, and securities issued by U.S. government sponsored entities.
The Right Tools for the Job
The PDCF, CPFF, and particularly the MMLF are designed to directly help address liquidity concerns arising from the current imbalance between supply and demand in the money markets. The terms of the MMLF encourages the purchase of CP by banks and broker-dealers insofar as they provide a loan with the same tenor as the commercial paper tendered, and this loan is non-recourse. As such, the bank or broker-dealer is truly an intermediary and thus not taking credit or market risk should they purchase commercial paper and then provide it to the Fed as collateral for a loan. Also, the Fed, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) have all agreed to neutralize the usual regulatory-capital and leverage implications for the banks and broker-dealers participating in the program that they might ordinarily incur when borrowing funds from a counterparty. In short, the MMLF provides a reliable buyer (the Fed) for money market instruments that have otherwise been difficult for money market funds to sell.
We are encouraged by the recent actions from the Fed as they demonstrate their focus on bringing liquidity to asset classes showing distress. While we do not expect any one of these measures will by itself reduce the large amount of securities currently being held by the dealers – which discourages them from buying more and providing liquid markets – the combination of the PDCF, CPFF, and MMLF are welcome additions and have the potential to help ease liquidity back into short-term securities markets.
Improving liquidity in the nation’s money markets is a necessary, but not sufficient, condition for markets and the U.S. economy to recover. In our view, policymakers like the Fed have learned from the Global Financial Crisis and will be forceful in addressing this and any other liquidity concerns. While the options available to the Fed are ill-equipped to stopping a virus, we believe they are well-equipped to provide liquidity.
It will take some time to see how the market responds to the measures, and whether further measures will be needed or possibly even modifications to the aforementioned facilities just announced. Should we see the global benchmark for short-term lending, the London Interbank Offered Rate (LIBOR), start to decline following the introduction of these programs, it might be interpreted as a sign that the Fed’s tools are working by alleviating funding pressures and helping liquidity slowly flow back into the short-term markets. If the CFPP, PDCF or MMLF do not have the desired effect on liquidity, we would expect that the Fed will continue pursuing new tools or modifying old ones to help improve the functioning of markets.