With markets well into late cycle, cash, or Money Market Funds (MMFs), are increasingly being considered as part of asset allocation decisions, given their primary objectives to provide a high degree of liquidity alongside preservation of capital, and yield, a tertiary consideration. Investors must therefore familiarise themselves with the regulatory reform driven changes to MMFs in recent years including the October 2016 US Money Market Reform and European Money Market Reform in 2019. We may be familiar with the terms constant net asset value (NAV) fund or variable NAV fund, but what is a low volatility NAV fund and how does it work? Focusing on the recent European reform, we’ll explore what the new regulations really mean for investors and how that experience will compare to what happened in the US.
Brief background to European Reform
European Money Market Regulation came into effect on July 21st 2018 for new funds, and existing, in-scope funds were required to submit an application for authorisation to the relevant authority by January 21st 2019 for conversion to the new rules shortly thereafter. Some asset managers converted before this final deadline, including JPMorgan Asset Management which moved on December 3rd 2018. Prior to reform, the European constant net asset value (NAV) universe had €635bn AUM as at June 1st 2018 and AUM has grown to €657bn as at March 22nd 2019 , showing that the market has not experienced any displacement of assets during the reform implementation.
Optionality in the market
The new European regulations introduce optionality into the money market space with 2 classifications of MMF and 3 structural options. MMFs can be classified as Short-term MMFs (akin to the existing conservative investment restrictions under the ESMA Short–Term Money Market Fund definition, including a maximum WAM of 60 days and maximum WAL of 120 days) or Standard MMFs (reflect the existing ESMA Money Market Fund definition, including a maximum WAM of 6 months and maximum WAL of one year).
Furthermore MMFs can be structured as one of the following:
Public Debt Constant NAV MMFs (CNAV) which can retain a stable NAV but must invest 99.5% of their assets into government debt instruments, reverse repos collateralised with government debt, and cash
Low Volatility NAV MMFs (LVNAV) can maintain a constant dealing NAV if certain criteria are met, including that the market NAV of the fund does not deviate from the dealing NAV by more than 20 basis points
Variable NAV MMFs (VNAV) price their assets using market pricing and therefore offer a fluctuating dealing NAV
Reverse Distribution Mechanism
Reverse Distribution Mechanism (RDM) is a share cancellation mechanism that allowed for prevailing market negative yields to be passed to investors while still maintaining a stable NAV and had been utilised by Euro currency MMFs while short term EUR rates remained in negative territory. The European Commission expressed opinion in letters dated January 2018 and October 2018 that share cancellation mechanisms are not compatible with MMF Regulation. To that end, European MMFs ceased to use RDM prior to March 21st 2019.
CNAV and LVNAV need to hold a minimum 10% in Daily Liquid Assets (DLA), and 30% in Weekly Liquid Assets (WLA), while the VNAV funds need to hold 7.5% and 15% respectively.
In order to ensure compliance with weekly liquidity thresholds the regulations have introduced a double-lock test on CNAVs and LVNAVs structures, whereby if both a fund’s WLA falls below 30% and the fund experiences a net redemption of greater than 10% on the same day, then the board may choose to apply one of more of 4 options, 1. Take no action, 2. Charge liquidity fees on redemptions 3. Implement redemption gates 4. Suspend redemptions for up to 15 working days. If WLA falls below 10% then the board shall apply one of more of 1. Liquidity fees on redemptions 2. Suspend redemptions for up to 15 working days.
In reality, prospectuses in Europe, have for many years included the ability to impose a gate or a fee and the introduction of the double-lock test as the first threshold, after which the board can still choose not to impose gates or fees, gives investors a clearer understanding of the circumstances in which these mechanisms can be invoked.
How have clients reacted to the changes?
In Europe the majority of clients previously invested in Government CNAV funds transitioned to the new Public Debt CNAV funds. Client who were invested in Non-Government or “Prime” CNAV funds generally moved to the new LVNAV structure. There was little displacement of assets during fund platform conversions and this benign transition differed to US Money Market Reform when, just ahead of the October 2016 conversion date, we saw the migration of assets out of Prime MMFs into Government MMFs (chart 1) and a widening of 3month LIBOR (chart 2) as Prime funds anticipated these outflows and built cash. The reason we saw this behaviour from US clients was because under the new US regulations, Government funds would remain as CNAV but, in contrast to Europe, they would not be subject to provisions to impose gates or fees. Prime funds on the other hand had to convert to a fully mark-to-market VNAV structure and could be subject to gates and fees.
In summary, European Money Market Reform introduces optionality for investors in the short term space and although some fund structures are changing, these features are already familiar to investors and the transition has been as smooth as anticipated.
President Trump’s Legacy on the Federal Reserve
President Trump had been presented with the opportunity to make a profound impact on the Federal Reserve (Fed). Since his election in 2016, he has had the ability to appoint new individuals for five of the seven Board of Governor seats that make up the permanent voting members of the FOMC, as well as appoint a new Fed Chair. Such an opportunity has rarely been available to a President so quickly into a first term because it is unusual for so many spots to be vacant at once. However, during the second term of the Obama administration, a number of prominent and long-standing members of the Board departed and as a result of political gridlock, the seats were left largely unfilled: no new Board members joined between July 2014 and September 2017 despite the departure of 5 members during those same years.
President Trump started to stray from tradition early by first deciding not to reappoint Chair Janet Yellen (opening up yet another spot). New Presidents have historically reappointed sitting Fed chairs for additional terms, even if the chair was appointed by a president from the opposing party (ie both President Bush and Obama appointed and reappointed Ben Bernanke while Alan Greenspan was first appointed by Ronald Reagan and reappointed by Clinton and Bush). Following the decision to appoint Chair Powell to replace Janet Yellen, only two of the seven seats on the Board of Governors predated Trump’s election: the new Fed Chair Jerome Powell and Governor Lael Brainard. Since then, the President has brought on Richard Clarida, Randy Quarles and Michelle Bowman. These appointments were all broadly accepted by the economic and political majorities and were mainly bipartisan. Randy Quarles was appointed to focus on bank regulation; Michelle Bowman filled a need for a community banker and Richard Clarida who was chosen for the Vice Chair position brought experience as an established economist but also a market practitioner. With the Board feeling fuller than it had in many years, but significantly more green, the FOMC continued on the trail previously blazed by Chair Yellen: gradual rate hikes and a slow balance sheet rundown that would be like watching paint dry. And just like that, it appeared that President Trump’s great opportunity to shake things up at the Federal Reserve had come and gone with little fan-fare. With GDP averaging 3% in 2018 and job growth averaging of over 200k per month, hardly anyone could complain – even with the Fed raising rates quarterly and slowly shrinking the balance sheet by 50 billion a month at its max pace.
President Trump has been consistently more vocal about his views on the Fed and monetary policy compared to Presidents of recent history – even when things in the economy were running relatively smoothly. That being said, criticism of the Federal Reserve is not really unusual – the Fed has been a target of political critics since its creation in 1914 but has managed to credibly build independence from political influence since the Treasury-Fed accord in 1951. Trump has managed to break many unwritten rules, including tweeting about the outcome of the payrolls report (of which the President gets an exclusive early look) before it was released in June 2018. President Trump’s tone really started to shift in Q4 2018 when the stock market took a dive briefly into correction territory. Since then the Fed has set forward a plan for ending the balance sheet rundown by September 2019 as well as indicated rate hikes would likely be on hold for all of 2019. Arguably President Trump’s vocal criticism may be in itself Trump’s largest legacy on the Fed. The textbooks will debate the extent to which his words truly did impact the Fed’s decision to pivot more dovishly this year. Beyond his rhetoric, he has no direct control over the FOMC and even his legal ability to remove the Chair is questionable. As Trump has admitted himself, “I guess I’m stuck with you”. However, he still has two more Fed seats to fill! Trump’s nominees during the last Congress, Nellie Liang and Marvin Goodfriend, both got lost in the shuffle. This was perhaps to Trump’s advantage because both of those picks came from within the Federal Reserve system and were unlikely to provide the change of direction Trump was yearning for. Now, he has two new names: Stephen Moore, a writer and economic advisor to the President and Herman Cain, a former Presidential candidate. For the first time, Trump’s appointments have been in line with an agenda to choose less mainstream candidates with backgrounds that are more political than academic or market focused. But even if they are confirmed by the Senate, will they be able to deliver for Trump? The short answer is it is unlikely.
Despite the Fed’s unambiguous pivot towards easier monetary policy this year, President Trump has been pressing the Fed for even more policy easing by recently stating rate cuts and quantitative easing are now needed. While both nominees have criticized the Fed’s policy decisions to raise rates and run down the balance sheet last year and prefer policy to be easier going forward (in line with Trump’s view), neither Moore nor Cain’s record clearly indicates they would be willing to juice the economy in the near term with the risk of losing credibility or creating instability over the long term. Cain has been a proponent of the gold standard and Moore has recently written an op-ed about a monetary policy rule based on commodity prices. Neither of these ideas provides much confidence that these candidates have an understanding of the basic tenants of monetary policy or macroeconomics. What is perhaps more concerning is that while Cain & Moore were advocating for a hard money stance during the Obama administration, with the backing of President Trump they are both now advocating for easier policy; this abrupt shift highlights the political nature of their views. The political connections between the candidates and President Trump are numerous: Moore advised Cain on his 9-9-9 tax policy proposal only to later advise the President on his 2017 tax overhaul. Both Moore and Cain have been faced with intense scrutiny from politicians and well-known economists since their names have been brought forward suggesting that their nominations and Senate votes may not be straightforward.
It is understood that the Chair is quite influential in swaying the direction of the committee and the addition of two more members are unlikely to influence the majority – in fact, it may actually have the unintended effect of making the majority unite even more strongly. For instance, if the two new appointees were to choose to frequently dissent at FOMC decisions and serve as a mouthpiece for Trump economic policy, it is likely that other FOMC members who would have considered dissenting would refrain especially to avoid a symbolically large number of dissenters which would signal a loss of confidence in the leadership of the Chair.
Trump should not despair; the Fed has adjusted its policy in response to tightening financial conditions in Q4 and moderating growth appropriately such that the economy should continue to run strong and the cycle should extend to be the longest in history. In addition, the Fed’s current monetary policy review has the potential to set the Fed on an even more dovish path focused on boosting inflation. Trump may end up getting what he wants – in fact, the Fed has already moved much of the way there by ending balance sheet normalization and having shifted their rate policy bias to equal likelihood of rate hikes and rate cuts. However, rate cuts will not come because Trump tweeted it or his new appointments were directed to vote for it but because the economy and the market signaled it should be so.
While my outlook on the political influences within the Federal Reserve remains relatively benign for now, the growing impact of politics on monetary policy is clear, and exemplifies our current political climate. Within not only the White House but across Congress as well, there is a growing desire to stimulate the economy in an effort to solve or mask structural economic challenges that currently exist in the United States such as wealth inequality and low productivity growth. Democratic presidential candidates and congress members are talking about MMT, the Trump administration is talking about QE infinity while even the Fed is considering a strategy to engineer higher inflation. Reflecting on the coordinated rise of all of these discussions, it is clear that the timing of these theories is not a coincidence but a window into the issues policy makers across the developed world are grappling with.