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Money Market Funds Are Back in Vogue

Money Market Funds
Written by Andy

Money-market funds and tech shares have both enjoyed a resurgence in recent times. These funds are highly influenced by changes in interest rates.

Money market funds, which mainly invest in secure assets like short-term government debt, have experienced a significant increase in returns that far surpass the interest rates that banks offer to depositors. This surge is due to the Federal Reserve’s rapid increase in borrowing costs over the past year.

According to Crane Data, the average yield on money-market funds is currently 4.6% – the highest it’s been since the 2008 financial crisis. This represents a significant increase from the 0.02% yield observed at the start of 2022.

According to Doug Spratley, who is the head of US money market trading at T Rowe Price, individuals who were earning a mere half a percent in bank accounts were disregarding the 4 percent they could earn in money market funds. However, with the recent surge in returns, they have now received a significant boost in returns. He likened this to a “big swift kick in the pants.”

Nafis Smith, who oversees more than $455 billion in money-market fund assets as the head of Vanguard’s taxable money markets group, points out that the recent period of low interest rates has made money-market funds an attractive option for investors looking to park their cash.

During the banking sector’s turbulence, there was an initial flight of deposits from smaller banks to the largest U.S. banks. However, the uncertainty led some customers to become uncomfortable holding balances in the commercial banking system above the $250,000 insured by the Federal Deposit Insurance Corp.

Money-market funds have emerged as an appealing option and are often seen as a cash substitute since they invest in easily traded debt securities.

Refinitiv Lipper data through Wednesday shows that U.S. money-market funds have seen a net inflow of $336 billion this year (2023), with $283 billion added in March 2023 alone – the highest monthly sum since April 2020. This marks a turnaround from last year when the funds experienced nearly $46 billion in outflows.

It is important to note that a significant portion of the money held in money market funds ultimately ends up outside of the banking system. This is because these funds heavily rely on a Federal Reserve facility that provides lucrative interest rates for overnight parking of cash at the central bank. Andrew Levin, who has previously worked for the Fed for 20 years, views the continuous inflow of cash into money market funds, and consequently, the central bank’s overnight facility, as “an accident waiting to happen.”

The utilization of the reverse repo facility has increased in recent weeks and the daily levels are currently around $2.3tn. Levin, who is a former Fed employee and currently a professor at Dartmouth College, expressed concerns about the potential stress on smaller banks if more depositors opt to invest in money market funds that eventually end up being parked at the Fed. This creates a paradoxical situation where the Fed’s own facility aimed at stabilizing and securing the banking system becomes a vulnerability in the overall financial ecosystem.

Money market funds’ heavy use of the Fed facility for parking cash overnight means that a significant portion of their assets end up outside the banking system, potentially leaving banks with fewer deposits and less incentive to lend. While money market funds are not deposit-taking institutions, their assets would still be within the banking system if they were not using the Fed facility.

Fed Repo Overnight Facility

It is also worth noting that money-market funds may lose some of their appeal if the Federal Reserve starts to cut interest rates later this year, as predicted by traders in the derivatives market.

Last week, the central bank raised rates by another quarter-percentage-point, pushing the benchmark federal-funds rate to 4.75% to 5% – the highest it has been since September 2007. However, the Fed also indicated that the banking-system unrest might bring an early end to its rate-hike campaign, contrary to earlier expectations. Torsten Slok, who serves as the chief economist of Apollo Global Management, asserts that the Federal Reserve will need to maintain high interest rates to manage inflation. As a result, the yields on money-market funds are expected to remain high for the next several months. One argument in favour is that those funds are not on the bank’s or broker’s balance sheet, so they are a good place to put uninsured deposit money.

I can see a scenario where more people keep piling into money market funds (or treasury money market funds), especially retirees and business money managers, once they figure out how. This might not be good for banks in general (which are paying depositors between 0.03% and 1% APY in money market/savings). For example, VMFXX from Vanguard is paying net 4.66% APY (APY 4.77% after expense of 0.11%, 4.61% for TMCXX/BlackRock and net 4.35% for SWVXX/Schwab) while 4-week T-bill is paying APY 4.69% as of yesterday. Is it really that attractive to gain the extra (0.03% to 0.34%) yield (if you can directly buy VMFXX from Vanguard, TMCXX from BlackRock/Merill Lynch, or SWVXX from Schwab) to take the (small) duration risk? Some (sophisticated investors) might think so; but I bet most of us will be happy with the related high yield for now and its liquidity, especially for those of us who can buy them in tax-deferred accounts or live in a state (like NH, TX, FL) without state income tax. Meanwhile, some brokers are charging 50bp commission in and out on on second rate money market funds which themselves charge 50bp a year for management.

Be wary though that money market funds do not carry FDIC protection. Institutions will do everything they can to keep them at $1/share but you are counting on the individual institution staying solvent. One or two MMFs went below $1 per share during the 2008 crisis. This happened because they were investing in CP issued by corporates and asset backed securitisations. However, I believe most of the higher quality ones now just buy treasuries. So I believe the risk is more on execution/fraud – eg they say they invest in treasuries but then they go do something else.

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Andy

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