Squeezing extra yield from US dollar cash has become a little more rewarding (and dare we even say exciting?) now that, for money market funds in general, the Federal Reserve (Fed) is raising interest rates and, for prime funds in particular, the U.S. Securities and Exchange Commission (SEC) has implemented money market reform.
Due to near-zero interest rates and massive quantitative easing programmes over the last decade, money markets funds had not been as attractive as bank deposits for a number of market participants. Now, however, this situation is changing. Some of the reversal is due to changes in money market fund yields; some of the reversal is due to Basel III regulation, which has caused banks to shed a significant amount of non-operational overnight and short-term deposits (Exhibit 1 and Exhibit 2).
In December 2015, with labour and inflation indicators moving towards targets, the Federal Reserve initiated the process of normalizing monetary policy, raising interest rates for the first time in almost 10 years. Since then it has hiked twice more, most recently in March of this year (Exhibit 3). Prior to the first hike, government money market funds yielded close to 0%. After three interest rate hikes, they now yield approximately 0.70%, which is a lot more competitive.
In October 2016, the SEC introduced US money market industry reforms, requiring institutional prime funds to implement liquidity fees and gates in times of stress and to float their NAV. These changes caused hundreds of billions of dollars to switch from prime funds into government money market funds. As a result of this flow of funds, the approximate yield differential between prime funds and government money market funds went from 10 basis points (bps) in late 2015 to 35 bps today. At about 1.05% yield, prime funds may now represent a very attractive option for cash investors vs. government money market funds and bank deposits.
A rising rate environment benefits low duration strategies, particularly money market funds—as discussed in J.P. Morgan Global Liquidity’s “Rising Rates” white paper. Compared to history, however, the current pace of hikes is relatively slow, which means a small amount of extra duration has enhanced returns without adding a significant amount of risk. In fact, the sweet spot for front-end investors in this hiking cycle has been in ultra-short strategies, which have a yield of between 1.2% and 1.6% while targeting a weighted average duration of about half a year.
With this in mind, US dollar money market funds and ultra-short strategies appear increasingly attractive, the former as a vehicle for liquid cash and the latter as a way to effectively shorten duration risk while maintaining a decent risk-adjusted return. With so much front end cash in motion, what strategies will you choose?
Prime funds are money market funds governed by Rule 2a-7 of the Investment Company Act of 1940 that can invest in both government and credit securities.
Government money market funds are money market funds governed by Rule 2a-7 of the Investment Company Act of 1940 that can only invest in government securities.
‘Rising Rates; managing liquidity through periods of rising interest rates’, J.P. Morgan Asset Management; as of 30 September 2013.