By Barbara Shegog
With official rates rising and new financial regulation kicking in, it could be a year of action.
We expect 2016 to be an interesting time for short-term cash management what with looming new rules and rising rates.
First, who knew most of 2015 would come and go without a Fed rate hike? As iTreasurer went to press Janet Yellen et al finally pulled the trigger. Now what to expect in 2016? It could finally be the year for even more Fed action, i.e., perhaps another tick up in the federal funds rate. But does it even matter? Rates have not waited for Fed action and have started an upward climb on their own. Liquidity will still be an issue as more regulation takes effect. An interesting twist to 2016 will be watching new products and markets develop to take advantage of the supply/demand imbalance created by money market fund reform and changing bank regulation.
Liquidity: Still a Growing Concern
For a fixed-income investor, the greatest fear is not being able to sell bonds when you need liquidity. Corporate debt outstanding is at the highest level and deals are five times over-subscribed.
A similar story can be found on the secondary market where daily volume is at an all time high. We are also not experiencing wider bid-ask spreads. Wider spreads are typically found in less liquid markets. Where is the liquidity crunch everyone is talking about? Dealer inventory is driving this story. New regulations have made it more expensive for brokers to hold that inventory. As a result, fixed-income trades have become hard to transact through the dealer networks, giving the appearance of less liquid markets.
Peer-to-peer trading is one solution that has emerged and will continue to develop in 2016. Technology today is helping sellers find borrowers. Electronic trading is picking up steam, similar to the equity market a decade ago; this type of trading could improve liquidity, as it will allow buyers and sellers to bypass the dealers and conduct peer-to-peer trading. Although it is still too early to understand what the future of short-term cash investing will bring, one thing is for sure: liquidity risk is becoming an increasing concern.
Will Prime Funds Survive new Regulation?
Money market fund reform was announced in 2014 for implementation in October of 2016. Regulation has three key components: floating NAV, the ability for fund management to suspend redemptions, and to impose redemption fees. The success of prime funds is largely attributable to their being a no-brainer; regulation, however, will make them anything but, and investors will start considering alternatives.
Investors are starting to do the math and discovering that staying in prime funds is not worth the yield differential to government funds (which are keeping a fixed NAV) and the hassle of a floating NAV and worse yet, redemption fees and gates. Prime fund managers are also doing the math and several fund complexes are eliminating prime funds or expanding alternatives. Upwards of $200 billion of prime funds has already converted to government-only funds, with more transfers anticipated from both institutional funds and investors.
In 2016 it is expected that excess demand for government money market funds will exceed limited supply and funds could potentially close to new investors. Although it is not expected that prime funds will go away in 2016, they won’t be as easy to work with as investors are likely to have to give extended notice for withdrawal and possibly pay a fee to redeem. Dollar-in/dollar-out is no longer the assumption. The landscape of products offered is certainly going to change.
Slow and Steady Rate Movement in 2016?
This low interest-rate story will be with us for some time, even once the Fed starts raising rates, as it has loudly telegraphed its plans to increase rates gradually. In addition to slow and gradual increases, the currently supply and demand imbalances will keep rates low for the foreseeable future. The supply of short-dated “safe” assets has dramatically decreased, with T-bills down by $600bn, agency discount notes down by $500bn and dealer repo balances down $300bn. This decline in supply is further challenged by the increase in demand for short-term assets as a result of money market reform and lower global yields. Income is the short-term investor’s friend, and can offset small negative price returns from gradual interest rate increases.
Liquidity issues are expected to continue and possibly become more pronounced as regulation tightens and money market regulations kick in in fall 2016. New investment options and ways to trade are on the horizon. Ride out the interest rate increases by staying invested and understanding your risk tolerances. Enjoy what can be billed as an exciting year to come in cash management.