We haven't even really gotten started with rate hikes and the Federal Reserve is already worried that if interest rates go up, they'll only need to come right back down again. As it stands today, any number of factors could force the Fed to reverse course (on its plan to raise rates) and ultimately cut rates: A shock to the U.S. economy from abroad, persistently low inflation, some new financial bubble bursting and slamming the economy, or lost momentum in a business cycle which, at 83 months, is already longer than 29 of the 33 expansions the U.S. economy has experienced since 1854.
What's more, among 65 economists recently surveyed by the Wall Street Journal, more than half said it was somewhat or very likely that the Fed's benchmark federal funds rate would be back near zero within the next five years. Ten said the Fed might even push rates into negative territory!
In addition to the usual suspects, there is yet another trigger that may help to keep rates low, and it stems from a highly unlikely source: Money market fund reform.
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A Lesson in History
Back in 2008, the Primary Fund, a $65 billion money market fund, announced that its customers might lose money. The fund said that because the value of some of its investments had fallen, customers had only $0.97 for each dollar they had invested in the fund. That announcement marked only the second time in history when a money market fund had "broken the buck" and near panic ensued.
Billions upon billions of dollars were pledged during the financial crisis by big banks and fund management companies to rescue affiliated money market funds that were caught holding mortgage securities that were deteriorating rapidly in value. In the end, the emergency rescue efforts succeeded, but the means to those ends were something federal regulators did not want to see happen again.
Money Market Fund Reform
In July 2014, the Securities and Exchange Commission announced substantial amendments to the rules governing money market funds. The changes are being phased in over time, with the most significant provisions requiring compliance by October 2016. The regulatory changes are intended to help create more stability within money market funds in times of stress and to help protect shareholders. In other words, the changes are designed to discourage runs on money market funds by investors.
Floating NAV
The cornerstone of the SEC's reform requires institutional money market funds to "float" their net asset value per share, or share price, so that it reflects the fair value of the investments held in the fund. This means the per share value of the fund would be based on the current market price of its securities and would therefore fluctuate based on the market value of its investments. NAV will be priced to four decimal places for money market funds. This is a significant change from the current structure in which all money market funds generally maintain a stable $1 per share NAV.
The floating NAV rule does not apply to retail and government money market funds. Retail money market funds will be defined as funds with policies and procedures reasonably designed to limit the beneficial owners to "natural persons." Government funds are those that hold securities such as U.S. Treasuries, U.S. backed debt or securities issued by U.S. federal agencies.
Institutional money market funds, while not specifically defined, are basically anything that retail and government funds are not and will include account types in which the beneficial owner is not a natural person, i.e. corporations, endowments, defined benefit plans, etc.
Liquidity Fees and Redemption Gates
In addition to the floating NAV change, the SEC reform rules include provisions for liquidity fees and redemption gates. A fund may impose liquidity fees of up to 2% on redemptions, or temporarily suspend (gate) redemptions for up to 10 days in a 90-day period, if a fund's weekly liquid assets fall below 30% of its total assets. If a fund's weekly liquid assets drop below 10% of total assets, the fund would be required to impose a liquidity fee of 1% on all redemptions unless it determines that imposing such a fee would not be in the best interest of the fund. Again, the punitive nature of these fees and restrictions are to prevent a run on money market funds during times of stress.
What's All This Have to do With Interest Rates?
The liquidity fees and redemption gates provisions of the reform rules do not apply to government money market funds (nor does the floating NAV provision). This makes government funds highly attractive relative to other money market funds, especially to institutional investors.
With roughly 96% of U.S. corporations utilizing money market funds for investment purposes, let alone countless pensions, endowments and other institutions, government funds could see inflows in the trillions of dollars come October 2016 when the reform rules become effective. Those inflows will spark demand for U.S. Treasuries, U.S. backed securities and securities issued by U.S. federal agencies as money market fund managers put those cash inflows to work.
As large as the U.S. Treasury and agency markets are (about $15 trillion), it's hard to imagine demand of this magnitude not having an impact on prices and driving rates down.
In this bizarre world of negative interest rates and unprecedented easy money policy, it would seem we can add money market reform to the growing list of triggers that will contribute to continued low interest rates.
Matthew Butler is founder and managing principal of Elite Capital Management Group, LLC. He can be reached at 203-699-9662 or [email protected].
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