Over the past week, market watchers have noticed something which otherwise could be seen as a warning signal: there has been a dramatic move in swap spreads space, notably a substantial widening in recent days from what was until recently record tight - and negative - levels, coupled with a blow out in FX swaps, where the EURUSD has seen its cross-currency swap slide -3 bps today to -48 bps, the widest since July 2012. And, as UBS puts it in a report by Chirag Mirani overnight, "the recent move wider in swap spreads warrants attention."
However instead of reflecting funding pressures or financial market stress (more on that in a subsequent post), the move can be attributed to something more innocuous: money market reform, which according to UBS has played an important role in reversing the tightening trend in spreads that began in 2014. "In essence, the demand from prime money market funds for commercial paper is shrinking and is moving to USTs."
The impact is two-fold: while $300-500bn in outflows has been seen from prime money market funds, causing about 10-12bp of widening in front-end swap spreads, this development is also "effectively, a new source of balance sheet has been created for USTs via regulation."
For those who need some more background, it has been long documented that UST swap spreads tightened (see Figure 2) over the past few years as dealer balance-sheet for USTs shrunk, corporate issuance increased and as foreign central banks sold USTs to defend their currencies. This long standing swap spread tightening move was led by the long-end spreads and coincided with the October, 2014 UST flash crash (see Figure 2).
However, more recently, UST swap spreads have enjoyed a widening resurgence led by the front-end. Below, we discuss what has caused the widening move and in particular who is the new provider of balance sheet for front-end USTs.
Specifically, since the beginning of March, 2016, the 2-year, 5-year, 10-year and 30-year swap spreads have widened by 21bp, 13bp, 7bp and 11bp, respectively. As Figure 3 shows, short-end swap spreads have widened the most.
However, instead of a more ominous reason suggesting some ongoing credit market plumbing issues, UBS (as well as Goldman and other banks) is confident that the explanation for this recent move is related to money-market fund reform and it’s approaching full implementation deadline in mid-October.
Let us begin by reviewing these reforms and why they matter for front-end USTs
What are money market fund reforms?
On July 23, 2014, the SEC adopted money market fund reform rules that govern money market mutual funds with the intention to make money-market funds more resilient to market stress. In 2008 financial crisis, institutional prime money market funds went through severe redemptions and US Treasury had to create a temporary guarantee program. For reference, prime money market funds generally invest in commercial paper.
As per the SEC website, the latest rules require a floating net asset value (NAV) for institutional prime money market funds. The compliance deadline is noted as October 14, 2016. Specifically, the rules state:
“With a floating NAV, institutional prime money market funds (including institutional municipal money market funds) are required to value their portfolio securities using market-based factors and sell and redeem shares based on a floating NAV. These funds no longer will be allowed to use the special pricing and valuation conventions that currently permit them to maintain a constant share price of $1.00. With liquidity fees and redemption gates, money market fund boards have the ability to impose fees and gates during periods of stress.”
While prime money market funds would now have the ability to impose charges during periods of market stress, the government money market funds, typically invested in debt issued by the government and government agencies, are not subject to the new rule. As one would expect, investors' preference should have shifted to government securities based money-market funds. Indeed, since the announcement of the new regulation, the share of prime money market funds inoverall taxable money markets has declined by close to fifteen percentage points through May, 2015 (see Figure 4).
Where is this money going?
Most of this money has flown into government security based money market funds. Since the peak, prime money market funds have shrunk by about $340bn through May 2016, with recent stories indicating out-flows of another $100-$200bn. This suggests that the total outflows from prime money market funds have been close to $500bn.
For reference, as of May 2016, overall money market size is about $2.7 trillion, with prime money market funds making up about $1.1trn of the market. Thus, as of July 2016, one can estimate that the size of the prime money market funds is still close to $1trn.
Has there been a market impact?
The market impact has been quite meaningful already. Since the ~$500bn decline in prime money market funds net assets – starting in October, 2015- various short-end spreads have widened by about 10-12bp. Figure 5 shows 3-month libor/T-bill, 3-month commercial paper/T-bill and 2-year UST swap spreads.
Given the remaining prime money market size of ~$1.0trn, further shrinkage in outstanding assets is possible as we move closer to the October regulation compliance date. Based on the recent experience, we judge that roughly $500bn in outflows from prime money market fund can cause about 10-12bp of widening in front-end swap spreads (2-year and under).
What Happens Next?
According to UBS as we get closed to October, several clear trends will emerge: expect wider spreads, particularly if risk-aversion rises. Should the market encounter a bout of increased volatility - something one can no longer take for granted in this centrally-planned world - the new rules and the prospect of imposition of fees would likely encourage further outflows from prime money market funds as investors learn the regulatory implications. Thereby, increased risk aversion or higher market volatility should cause spreads to widen more than in the past. Over time, however, market should reach some equilibrium.
Secondly, given the shrinking demand for commercial paper, issuers are more likely to use longer-term financing to lock in their operational cost demand. This could put widening pressure on spreads beyond the very front-end.
But the most important implication is that suddenly a whole new buyer of outright Treasuries will emerge. UBS believs that since world yields are quite negative, USTs look quite attractive from that perspective. Since overseas demand for US Treasuries is likely to remain robust, and be conducive to continued spread widening. Notably, the combination of drivers supports widening of spreads both at the short-end and at the long-end of the curve.
In other words, out of the money-market frying pan and into the non-fire (for now) of short-end Treasurys, which however may be just as painful if the Fed does proceed to hike rates over the next few months, blowing out short-term yields and leading to substantial losses for asset managers.