personal views of a fed insider

Negative Net Yields

Money is being poured into the system, and it has no where to go. The ON RRP is the escape valve, but it is fixed at 0% when money market fund (“MMF”) management fees are around 0.2%. The stars are aligned for continued flow into the money fund space, pushing front end rates towards 0% as it ultimately flows down the ON RRP drain. The Fed will continue to pump $120b/month into the banking system, European bank balance sheets will be less willing to hold additional liquidity under daily average reporting (see this post), and SLR/LCR constraints will eventually bind big U.S. banks (see this post). MMFs have been waiving their fees to keep net yields positive (without waivers Fidelity’s flagship Govie fund would yield -0.09%), but that can’t last forever. Negative net yields are coming. Cash investors are unlikely to idly sit and watch their money evaporate. In this post we outline some options for cash investors, show why the marginal flows will move abroad, and suggest that this is functionally a surgical rate cut.

Fidelity’s $130b Institutional Gov Fund (FRGXX) would be increasingly negative yielding without fee waivers

What’s a Cash Investor to Do?

The dominant flows into MMFs have been into Government MMF – suggesting the marginal cash investor highly values safety. When negative net yields come these investors can move money along two dimensions – more credit risk and/or more duration risk. More credit risk means moving away from credit risk free government debt towards bank or corporate debt. More duration means moving out of the money market space (securities that mature within 397 days) to securities that mature around 2 to 3 years. Movement along these two dimensions would be similar to the portfolio re-balancing channel of QE, which boosted asset prices in the capital markets (ie equities/bonds).

While some cash investors may be pushed by negative net yields to move along the risk/duration curve, there are reasons to think that negative front-end rates may elicit a different reaction function than negative term premium. A cash investor that highly values safety is unlikely to move along either curve as it introduces the possibility of loss. At the moment, prime money funds are yielding barely more than government funds (and their fees are higher, so their net yields will eventually go negative too) and short-term bonds have been selling off (the market is trying to understand the path of policy under Fed’s new framework). These outcomes are likely unacceptable to the cash investor. The most straight forward solution for them is to stay within the money market space but look across currencies.

Money Markets are Global

Sophisticated cash investors view money markets as global – they look at their future cash needs, build out FX hedged curves, and then allocate accordingly. They can easily move into risk free foreign assets and hedge the FX exposure via FX forwards/swaps. The smaller cash investors may be stuck investing in Gov MMFs (who in turn will be stuck in the ON RRP), but the big money cash investors – sovereign funds, mega corp treasuries, international organizations – have broader capabilities and will use them to avoid negative returns. The smaller cash investors may eventually also rethink their approach as they watch their cash holdings evaporate, but that takes time and lengthy internal approval.

On its face, investing in foreign sovereign debt may seem silly when their yields are so much lower than U.S. yields. But FX hedging completely changes the calculus.

Foreign cash managers look at U.S. rates and wonder what the fuss is about

In a sense, the USD cash investor is not so much investing in FX hedged negative yielding foreign sovereign debt as they are lending dollars and holding risk free collateral (like a reverse repo investment). For example: an American cash investor lends $100 dollars to a Japanese Investor, who puts up the equivalent value of JPY on that loan as collateral. The American investor sends over the USD and receives in return JPY in his bank account. He does not want to take any bank credit risk, so he takes that JPY and purchases a JGB Bill (also, his bank would probably charge him negative rates on his JPY deposit anyway). The American Investor receives USD LIBOR from the Japanese Investor for the USD loan, but must pay a market rate (JPY LIBOR) on the JPY collateral put up by the Japanese Investor and also the FX swap basis. Fortunately, JPY LIBOR and basis are both negative. So the American Investor receives positive returns from USD LIBOR, the basis, JPY LIBOR, and suffers negative returns on his JGB investment. The “basis” is essentially the extra return needed to balance the market for USD loans against JPY cash collateral (a structural feature of the market is a much stronger demand by Japanese investors for USD than vice versa, so the basis has been persistently negative, see here for more details).

FX hedged Euro and JPY Bills offer a nice yield pick-up

To make this more concrete: the U.S. investor pays JPY 3M LIBOR (-0.07%), receives USD 3M LIBOR (0.2%), and pays the FX swap basis (-0.10%). In this example the U.S. investor would be earning 0.37% on the FX swap transaction while earning -0.1% on the 3M JGB. This nets him a return of 0.27%, compared to 0% T-Bills. There is some evidence that China manages parts of its dollar holdings this way.

The most direct implication of this cash reallocation would be a positive FX basis through an increased supply of dollars into the FX swap market. There is value in USD collateral (“convenience yield”) such that it will always yield less than an FX hedged foreign bond, but there is room for the spread to narrow. A slightly positive FX swap basis would imply a decline of USD hedging costs of about 10 to 15 bps for foreign investors. On the margins the incremental increase of flows out of the U.S. may also be dollar negative (which is to be expected from negative yields).

FX swap basis is structurally negative, widening on quarter-ends as banks reduce intermediation to window dress balance sheets

A Surgical Rate Cut

A move towards negative net yields would essentially be a rate cut, but a very targeted one. Unlike a proper rate-cut, the pain of negative net yields is isolated and mostly inflicted upon institutional cash investors (as they are the first to get pushed out of banks and end up in MMFs). The side effects of negative rates are avoided: the banking system continues to earn IOR at 0.1%, and most everyone else holds bank deposits at or above 0%. The market effects of the rate cut would also be more targeted: a more positive FX swap basis and weaker dollar. This essentially eases global financial conditions (as rate cuts tend to do).

On the margins, U.S. assets would become more attractive from the prospective of foreign investors. At the moment FX hedged U.S. rates already offer a foreign investors around 100bps in yield pick-up. It’s not clear how much wider it needs be to attract foreign buyers – the official TIC data (which is lagged by a couple months) has yet to show a pick up in purchases. But eventually this yield differential will be too attractive to ignore. USD cash managers are happy to lend them the dollars.

FX Hedged 10 year Treasury returns are at multi-year highs

1 Comment

  1. Anonymous

    your contents are amazing. thanks for posting all these.

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