personal views of a former fed trader

Two Rotations

The 5bps RRP hike created a wedge between the opportunity costs of 2a-7 money market funds (“MMFs”) and non-MMF cash investors that is setting the stage for a tectonic rotation. By August month-end around $1t in Treasuries and Agencies held by MMFs will mature and most of the proceeds will be reinvested into the RRP. The RRP is offering the same yield as bills but allows MMFs to conserve their WAM/WAL dollars for more attractive investments. As the same time, some non-MMF cash investors will be moving out of their 1bps MMF shares or 0% bank deposits and into slightly higher yielding bills. MMF portfolios are earning more from the 5bps RRP hike, but passing on virtually none of it to their investors. This makes 5bps bill yields attractive to non-MMF cash investors. At the same time, bill supply is shrinking as Treasury cuts issuance to stay under the debt ceiling. In this post we preview the two upcoming rotations created by the 5bps RRP wedge, and suggest that these forces will slowly push short-dated bills back towards 0%.

MMFs Move From Bills to RRP

With bills and agencies trading around the 5bps RRP offering rate, MMFs will roll most of their upcoming maturities into the RRP. At the same yield, MMFs prefer the RRP to bills/agencies because the RRP conserves their portfolio’s weighted average life (“WAL”) and weighted average maturity (“WAM”). MMF are highly regulated in the composition and maturity structure of their holdings. Two constraints are a 120 day limit on WAL and a 60 day limit on WAM, which act to limit the amount of duration a MMF can hold. MMFs usually use their “WAM/WAL dollars” to pick up extra yield along the curve, and would be wasting it on bills/agencies without any extra yield pick-up over the RRP. The RRP is offering the same credit quality, yield, and regulatory liquidity as bills but with a 1 day maturity.

MMF regulatory filings as of June month-end show around $1t in bills and agencies will mature by the end of August (excluding Treasury only funds, who can only roll into Treasuries). Some of the prime MMFs will try to roll into time deposits at LIBOR, and some of the government funds will be rummaging through short dated coupons as they roll down the curve for extra yield. But investment opportunities are scarce, so most of the money will rotate into the RRP. There’s already almost $800b in the RRP that would pounce at an opportunity to earn an extra basis point. A rough assumption of a 75% roll-over into the RRP suggests RRP participation of $1.5t by August month-end. Note that RRP counterparty limits are illusory, with recent Fed minutes already hinting at further increases.

Cash Investors Move From MMF to Bills

Most Govie funds have portfolios yielding ~7-8bps, take 6bps as fees, and offer investors 1bps

Some institutional investors will move out of Government MMFs into bills, which are higher yielding and more versatile. For most investors in Government MMF, the 5bps RRP hike never occurred and they are still receiving just 1bps. The Fed’s 5bps adjustment moved gross Government MMF portfolio yields up to around 7bps, but that may not even cover their operating costs. MMF management fees vary across the hiking cycle, with fees last cycle rising from a low of ~12bps when rates were 0% to ~40bps as the hiking cycle proceeded. The current implied management fees of around 6bps would be at 10 year lows and suggests that most Government MMF shares will yield 1bps for the foreseeable future.

Investors who just need a place to park their cash will be happy with 1bps, but larger investors will see that bills are yielding slightly more and reach for the extra bps. In addition to higher yield, bills have value as high quality collateral that can be pledged with minimal haircuts for financial transactions. Some investors holding 0% deposits at commercial banks will also be attracted into bills. The rotation into bills will be slower, but involves a large investor base that continues to grow via QE.

Two Reservation Prices

The 5bps RRP hike placed a wedge between RRP counterparties and non-RRP counterparties. RRP counterparties – the $5t U.S. MMF complex – will not invest in anything offering less than the 5bps RRP offering rate. (Note that the Foreign repo pool rate is set equal to the RRP, so foreign CBs have access to 5bps as well). Non-RRP counterparties – everyone else – faces reservation prices of 0bps in a bank deposit or 1bps in a Government MMF. In this context bill/agency yields have a ceiling of ~5bps, but a bias to move lower towards 0% as non-RRP counterparties rotate into bills/agencies.

The amount of dollars held by non-RRP counterparties is vast, global, and continues to grow each month from on-going QE. These include mutual funds, local governments, foreign investors, corporation treasurers etc. The great majority do not care for a few extra bps, but some will. A 5bps yield on pristine USD cash like collateral in a world of negative rates is attractive. Note that bills and agencies have historically often traded below the RRP. In addition, Treasury has begun to cut bill issuance to stay under the debt ceiling target. The cuts will continue until the debt ceiling is resolved, which can be quick but usually drags on for weeks. Increasing interest from non-RRP counterparties combined with declining bill supply might be enough to push short bills towards zero in the coming months.

8 Comments

  1. RB

    Hi Fedguy,

    Thank you again for an interesting write-up – Could you imagine a way, market interest in Bills could be parsed (and quantified) along the lines of (a) interest in Bills as operational collateral (lucratively re-hypothecated many times over in bilateral repo, I imagine) and (b) the more “traditional” interest in Bills as a short-term safe and liquid asset?

    • Joseph Wang

      That is really hard to do with public data. One rough way would be to look at all the bills held by MMFs (they hold half of all bills), and then just assume they are held as a short-term safe asset (MMFs to not re-pledge their collateral). You can look at primary dealer bill holdings and assume they are funded in repo. Beyond that I don’t think you can break it down anymore.

      • RB

        Ok, that makes sense, thank you. I have a small follow-up – in the context of the gradual move from unsecured to secured lending in money markets (cemented now by the rise of SOFR), people like Manmohan Singh, Jeff Snider and Carolyn Sissoko talk loads about the demand for “pristine collateral” and the related “collateral shortage” – acute, since the implosion of private ‘AAA’ paper in 2008 – what do you make of these arguments that Bill yields (and yields of other favoured Notes and Bonds further along the curve) will never recover, because of increased demand due to their status as sole “pristine collateral”? Or do you reckon this to be more of a sideshow?

        • Joseph Wang

          Bill yields will probably stay low because QE has created so many deposits looking for safe assets to park in. However, coupon issuance is at record highs and will continue to increase with more stimulus. It’s hard to see a shortage there. Bigger picture though – Fed is gradually exerting more control over rates across the curve. So where rates will be will largely be a policy choice.

  2. Nishcal Tamrakar

    In layman’s term , if i understood it correctly, USD strengthening??

    • Joseph Wang

      Don’t think it will have too much impact on fx. Maybe slight usd negative as bill yields move towards 0

  3. Keith

    What are the implications for longer duration? I.e. TLT ?

  4. Nick

    Great information – if the natural pressure on T-Bill yields are to stay below the RRP rate, would the only scenario for RRP to drain come from rate hikes + QT? Or could RRP drain in the absence of QT if T-Bill supply decreases?

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