My name is Kyongsoo Noh, and I am a portfolio manager on the ultrashort duration team here at JPMorgan. Welcome to the 2020 Q4 Guide to the Markets call for Global Liquidity investors. I wish everyone good health over the coming quarter. Over the next 10 minutes, I will be going over a handful of slides that we think are most relevant for front-end investors in the current environment.
First I am going to talk about some of Covid-19’s (“Covid”) ongoing effects on the US economy. Then, I will discuss our thoughts on the Fed and monetary policy. Finally, I will end on some strategy recommendations for short term fixed income investors.
We start on p. 59 in the Guide where we show Google mobility data. This data captures the movement of people over time by region. It is not a perfect measure of economic activity, but if we want an assessment of social distancing, mobility is a decent data series to use. While mobility still has yet to fully recover, it has rebounded significantly from the lows. On the left is the developed markets, and within that left chart, you can see that US mobility initially dropped by 44% but is now back to within about 12% of pre-Covid levels. That is a deep cut followed by a decent sized bounce; at the same time, however, we are still below normal levels. Keep that shape in the back your mind as we turn the next slide.
To continue our discussion on economics, we show US GDP data from p. 22 of the Guide. Similar to the big drop in mobility we showed on the prior page, we saw a 32% drop in annualized GDP growth in Q2; that is the downward needle-like shape on the right side of the left chart… but also corresponding to the bounce in mobility on the prior page, we are expecting about 30% annualized growth for Q3 GDP; it is not on this chart yet because the official data release for Q3 will be in late October, so it will be several weeks before we see the actual print.
Looking forward, we will likely experience above trend growth of about 3-5% for Q4. In other words, the pace of recovery will be positive but slower from now than what we saw in Q3. If you recall the shape of the mobility curve on the prior page, the slope of the recovery in mobility is getting flatter. This makes sense because we have added more activities that were just not available in March and April like eating in restaurants or watching professional sports on TV, but the addition of new activities is slowing. On top of that, there is a limit to the number of activities we add before we have a vaccine - business travel easily comes to mind as an example of something that will remain curtailed.
Now we turn to page 32 of the Guide where we have a deeper look into the downturn in the labor market. On the left, you see a drop of about 19 million jobs in Q2, and the subsequent recovery of about 8 million jobs in over the past few months. On the right, we have a breakdown of the most affected industries. It is not a surprise that the leisure and hospitality sectors top the list.
We should see 2 to 4 million more jobs return this quarter, which is a lot of jobs but that is a slower pace of job recovery than we saw in Q3. To reiterate what we said on the prior slide, we will likely see positive economic growth in Q4, but on this slide we acknowledge that a large number of people are still out of work.
Even if we expect positive growth in Q4, this quarter is not without risk. This is page 18 of the Guide; the bottom chart has the VIX, which is the volatility of the S&P500. There are a number of events that are causing some uncertainty in Q4: School re-openings will likely cause some increase in Covid cases. Flu season will compete for health care resources. Covid cases are increasing in Europe. The election could be closer than the polls suggest. Politics have delayed the next fiscal stimulus package.
Is there an anchor point for liquidity investors in the midst of these uncertainties? There is, and that anchor point is the Federal Reserve (“Fed”).
We’ll get to the Fed on the next slide, but before we go there, I’ll make a few brief comments on the election, which is not directly on this chart, but is nonetheless a source of some of the volatility. The most likely 3 outcomes are a Blue Wave (where the Democrats win the House, the Senate and the Presidency), a Red Wave (where the Republicans with the House, the Senate, and the Presidency), or a divided government where the Democrats win the House and the Presidency; and the Republicans keep the Senate) – I see each of those with about a roughly 1/3 equal chance of happening. It is not likely for Trump to keep the Presidency while the Democrats keep the House of Representatives, so we do not consider that to be an additional divided government scenario. People may ask, isn’t that last unlikely scenario the way the government is today? Yes, but remember that Trump was not on the ballot in 2018. Regardless of the election results, we believe the Fed, and not the election, will be the biggest driver of front end fixed income performance in Q4.
Turning to p. 38 of the Guide, we show the Federal Funds rate. As we just mentioned, economic risks from Covid have not gone away, and the economy is running below potential, characterized by a high jobless rate. This is precisely the time that the Fed must lead with monetary stimulus, and they have not disappointed.
We will not go over all the Covid crisis responses today, but we will highlight that the main policy action affecting liquidity investors is zero interest rate policy or ZIRP. This is illustrated on the right hand side of this chart. It is clear by this policy the Fed wants stable and cheap access to capital for high quality borrowers whether it be the US government, corporations, or even individuals. The Fed has been successful at steadying the market and reducing capital costs, but the flip side of lower interest rates is that government money market strategy yields are trending towards zero.
The question now is how long the Fed will keep rates at these low levels. To help answer this, we examine the Fed’s dual mandate. By law, the Fed must use its tools to help maintain stable prices and maximize employment in the US economy. In the table in the upper right, this means getting inflation to the Fed’s long run forecast of 2% and unemployment to its long run forecast of 4.1%. Also in that same table, you can see that current levels of inflation and unemployment are both well off target, which means we are not close to lift off today.
But what about if we get a successful vaccine? What does that means for rates? To help frame this, we turn to p. 39 of the Guide, where we explain the concept of average inflation targeting. If we get a successful global vaccine in 2021, which is possible, we could see inflation and unemployment trend towards Fed targets as early as 2022; this would normally increase the risk that the Fed would move off of ZIRP around that time. However, in August of this year, Chair Powell announced that the Fed will make monetary policy decisions on an average targeting basis, which means that if we face a period when inflation is running below 2%, they will tolerate a period when inflation is running above 2% to get the average to the target. To give you a sense of the length of time inflation can run above and below targets, take a look at the right chart; the time frame is in years not months. The upshot is that a successful vaccine and the potential economic boom that could come with it will not automatically trigger rate hikes. Because of this, in our view, the Fed is likely to maintain zero interest rate policy until at least 2023, and possibly longer.
This brings us to our summary and recommendations. Economically, the recovery should continue but the easy gains are over and Q4 should see around 3-5% growth. Having said that, we acknowledge that economic risks from the disease have not gone away, and there are still a lot of people out of work. With this as the backdrop, the Fed’s zero interest rate policy will remain in place, which has stabilized the market but at the cost of lowering investor returns. Even if we get a vaccine next year followed by a period of economic boom, the Fed should still remain accommodative until at least 2023 because of average inflation targeting.
What does that all mean from a liquidity investment standpoint? ZIRP will have much more bearing on the front end in Q4 than any of the US election possibilities. Longer term, because government money market strategies will likely be near zero percent yields for the next several years, if you are looking for higher returns in the liquidity space, prime and ultrashort strategies that buy credit are great options. These approaches are low enough in risk that they can weather the kind of volatility we expect for Q4. The key is to balance how much liquidity you need on a daily basis with how much you can earmark for a longer time horizon.
Because every situation is different, your JPMorgan Asset Management representative can help you think through what level of risk is appropriate for your objectives. Thank you for listening, and we look forward to speaking with you.
Hi, I’m Olivia Maguire, Sterling Money Market portfolio manager with the JPMorgan Asset Management Global Liquidity team in London. Thanks for joining our conversation today where I’m going to discuss the potential for negative rates in the UK.
Back in May 2020, the new Bank of England Governor, Andrew Bailey, first mentioned that negative rates were a tool under active review for the UK Monetary Policy Committee, or the MPC. Before that point the Governor and his predecessor, Mark Carney, had been more supportive of a lower bound that was close to, but above zero. Since those comments from Bailey in May, the market has adjusted to the expectation that Bank Rate in the UK could follow rates in Europe, Japan and Switzerland below zero into negative territory, and that previously cited challenges around communications and difficulties for banks and building societies in dealing with sub-zero rates may now have lessened or, can be overcome. In fact the MPC said in their latest meeting minutes for September that the Bank of England and the Prudential Regulation Authority, (the PRA), will commence “structural engagement on the operational considerations” of negative policy rates in the fourth quarter of 2020. That technical work, to ensure that the financial system can implement sub-zero rates will take time to complete according to Bailey, and the work itself does not actually signal that the Bank will act on reducing rates, however it is the next step to ensure that policy makers are ready for negative rates if needs be, or in the MPC’s own words, “should the outlook for inflation and output warrant it at some point during this period of low equilibrium rates”.
Economic data up to the September MPC meeting had held up better than expected but downside risks to the UK economy do remain; one risk is to employment as the more generous Government support programs, such as furlough schemes, come to an end; a second is the outcome of UK and EU Brexit trade negotiations and a third is the economic impact of further waves of Covid infections in the UK and globally.
Right now we believe that the MPC’s marginal tool of choice would be to extend Quantitative Easing, and so in the face of any downside risks materialising, they could ease monetary policy by increasing asset purchases from the current envelope of £745billion. Negative rates are firmly in the toolkit, but with the ongoing technical work to ensure the financial system is operationally ready for them, we do not anticipate that the Bank would implement sub-zero rates until at least the second quarter of 2021 or possibly later.
So what does this outlook mean for our investors? Well since Bank Rate was cut to 10 basis points in March this year, we have seen a correlated fall in gross yields across Sterling Liquidity strategies. As was our approach in other currencies, we do not intend to let mutual fund fees alone be the cause of a fund’s performance becoming negative. So where possible, we will waive fees in order to maintain a fund’s yield at zero or higher and we are already implementing this approach across Sterling Liquidity short-term funds.
If a fund’s gross yield were to approach negative levels, then some changes are required to Sterling Liquidity fund structures to deliver negative net yields, and regulatory frameworks require managers to provide specific prior notification to existing investors ahead of any proposed changes, as was the case with our EUR Liquidity strategies which have been operating ordinarily with negative yields since 2015.
In summary, while negative rates in the UK are now a distinct possibility, they won’t happen until the Bank of England has concluded technical and operational work on their feasibility, and while gross yields on JPMorgan Sterling Liquidity Strategies remain above zero, clients will receive a net yield of zero or higher.
Thanks for listening today & should you have any questions, or wish to discuss the topic further, please do not hesitate to contact your J.P. Morgan Asset Management representative who would be happy to put you in touch with us here on the investment desk.
Hi, this is Cecilia Junker, from our ultra-short, Managed Reserves team. I want to start by wishing you and your families well during these very challenging times.
2020 has been a difficult year for many of us. From the Covid-19 pandemic, and the economic disruptions that followed to the market volatility that ensued, 2020 will be a year for the history books. The forceful response of the Federal Reserve and Central Banks across the globe to stabilize markets proved effective and has driven yields to historic lows.
With the worst behind us, at least from a market perspective, the realities of a Zero Interest Rate Policy (ZIRP) in the US are in the forefront of all our minds. Now more than ever, with the front end of the curve firmly anchored at the zero bound, clients should look to re-assess their liquidity needs and think seriously about Cash Segmentation.
The strong returns and easy gains of the second and third quarter are now in our rear-view mirror. The Federal Reserve policy shift to average inflation targeting is signaling a clear commitment to keeping front end rates low. It would be prudent for cash investors to think about extending out a portion of their cash balances to pick up incremental yield. By segmenting your cash and stepping out the curve, you have the potential to enhance returns in your cash portfolios.
We typically divide cash investments into 3 broad categories, Operating Cash, Reserve Cash and Strategic Cash.
First is Operating Cash, the most conservative of your cash segments, which is used to meet the daily operating needs of your business. This cash generally requires daily liquidity and has a very low risk tolerance. It is typically invested in deposits or in a money market strategy with a weighted average maturity of 60days or less. Money market strategies could be offered as a government only option for the more risk averse investors, or for those seeking incremental yield you can consider a prime money market strategy which holds high quality credit to augment returns.
The next step beyond operating cash is what we refer to as “Reserve Cash”. For this sleeve , there is generally more visibility on forecasts, with a limited need to access this money for at least 6 to 12 months. Similar to operating cash, these investments would be characterized by the desire to minimize volatility as well as to preserve capital but would typically have a portfolio duration of up to one year. We believe that ultra-short duration portfolios with a conservative, high quality allocation to credit can provide liquidity investors with incremental returns on their reserve cash balances.
And last but not least is your Strategic Cash. This segment of your cash has not historically been required for operations or short-term needs, and generally has a minimum investment horizon of more than one year. A Short Duration strategy may be appropriate for this portion of your cash investments. This type of approach would typically have a duration of 1.5 to 2.5 years with a more robust set of eligible investments to enhance returns.
Navigating the challenges of Zero Interest Rates requires a thorough assessment of your cash needs, identifying the right strategy for each of your cash segments and tailoring a liquidity solution that best meets those needs.
At JP Morgan, we fully understand our clients’ need for Preserving capital, Ensuring Liquidity, Managing Risk and Maximizing return. We believe that utilizing a cash segmentation strategy, can provide investors with incremental risk-adjusted returns for their cash balances in these challenging times.
Should you have questions or wish to speak, please do not hesitate to contact your J.P. Morgan Asset Management representative who would be happy to put you in touch with us. In the meantime, thank you for joining the conversation, please take care of yourselves and stay healthy.
Over the summer, the easing of lock down measures, gradual reopening of economies and COVID case count curves remaining relatively under control – certainly helped to boost business and consumer sentiment.
This coupled by the colossal central bank support via ultra-low rates and QE programmes certainly has many of us looking at the markets with a glass half full mindset and risk markets continued their rebound.
Equities surged (especially big tech) , credit spreads tightened and capital markets were buoyant with new issuance surpassing even the most optimistic forecasts.
With economists fixated with ways to describe the shape of the recovery , be it V, extended V , W, square-root or even K; the economic and market data gathered over the past few months certainly backed up those strategists calling for a V shaped bounce.
The conviction levels supporting an extended V shape recovery faded late in the quarter as volatility picked up. The market sharpened focus on several headwinds that will increasingly play out on Q4 – from increasing COVID case counts and related social restrictions, to Vaccine worries, to hard Brexit concerns, and souring US/China relations. We know there are a lot of hurdles ahead. One of our major concerns at the moment is volatility picking up pre and perhaps post the US election – it’s very difficult to forecast how the markets will react as we head into the November election .. but we do expect a more volatile final quarter of the year. For investors focused on the front end of the curve, our market has also continued to heal and normalise. Measures of market stress and of huge importance, access to dealer balance sheets , which relates to market liquidity , are now at the very least back to pre covid levels.
Front end Credit Curves or term premium is also a lot flatter than it was pre covid , especially for banks. The European banks simply do not need as much senior funding from money markets considering the cheap funding available from the ECB … via the TLTRO. As a reminder, under certain criteria , European banks are now being PAID to borrow from the ECB up to a rate of 1%.
Considering the uncertain COVID backdrop there is clearly no stigma associated with banks taking advantage of this borrowing. The uptake has been huge with almost Eur1.5trillion borrowed so far taking excess liquidity in the Euro system to almost Eur3trillion. This wall of cheap funding for banks have driven funding levels for banks down to all-time lows.
So considering this dynamic , over the past several weeks we’ve witnessed a steady decline in yields in traditional cash solutions, such as AAA liquidity funds and we could be set to go lower.
Recent rhetoric from central bankers in the UK and Europe have suggested there could be room to cut rates further. For market pricing:
.. f/w curves in Europe are currently pricing the ECB to cut another 10bps by next summer – if correct, this would take the deposit rate to -60bps.
More immediately .. market pricing is showing Bank Rate in the UK as dipping into negative yield territory by Q2 next year – how negative probably depends on whether we have a hard Brexit or not.
And for the US , well negative rates are not on the table … yet .. but with the move to average inflation targeting .. we can safely say we are stuck at zero for multi years – the Fed pretty told us as much in their last meeting.
For our near term outlook, we are also increasingly concerned about second waves, localised lock downs leading to a slowing down of economic activity. Also, specific risks such as the US election or Brexit will dominate headlines and sentiment.
Considering these headwinds, we may begin to see a flight to quality and focus on liquidity once again especially when you considering the relatively low yields achievable further out the curve – where 10 year government yields are at or near historic lows. In this scenario, cash could well begin to be thought of as an asset class again, further reinforcing the positive technical we feel at the front end of the curve.
Money fund investors, especially in Europe have gotten used to the low (or negative) for longer mantra. With rates back at near zero in the US and the potential for more central banks to experiment with negative yields such as in the UK and New Zealand. Considering this backdrop, it may be appropriate for our clients to review of their cash management strategy. Asking themselves the question how much cash do we really need in an operational cash, same day product ?
It’s at time like these , when every basis point counts, that a cash segmentation exercise could help in an effort to mitigate the increasing cost of holding cash. As a solution provider, with significant experience in ultra short duration mandates your J.P. Morgan Asset Management Representative is well versed to discuss options
Hi, this is James McNerny, portfolio manager on our ultra-short, Managed Reserves team.
The third quarter of 2020 was characterized by a welcome reprieve from the volatility we saw earlier in the year. Following the 32% drop in annualized GDP growth in the second quarter, the much-anticipated bounce in growth indicators in the third quarter signaled a generally stronger-than-expected recovery thus far, albeit at a slowing pace. Retail sales, home sales and job growth were among the economic data points that surprised to the upside, especially the unemployment rate which fell to 7.9% in September.
In short term fixed income markets, interest rates in the front end of the curve were low and range bound through the quarter, with the 2yr US Treasury trading in a muted 6 basis point range around its average yield of just 0.14%. To put that into context, the trading range on the 2yr Treasury in the first quarter of the year was approximately 135 basis points. Of course, that was as the Fed cut the target overnight rate by 150bps.
But even with short term rates now skimming along at such low levels, we did have some big news from Fed Chair Powell in his August address to this year’s virtual Economic Policy Symposium typically held in Jackson Hole, Wyoming. In that speech he announced a major monetary policy shift for the Fed to flexible average inflation targeting. Instead of aiming for inflation to return to the Fed’s 2% target in the medium term, the Fed will now aim to return average inflation to their target over a longer period of time. This is due to the persistent under-achieving of that 2% target, particularly over the past ten years even with periods of extremely low unemployment. Very simply put, this shift means that periods when inflation is running below the 2% target will likely be offset by periods where the Fed will tolerate inflation running above the 2% target in order to achieve an average inflation rate of 2% overall. As long as inflation is underachieving the Fed’s target, they will be likely to maintain a more accommodative policy for an even longer timeframe in order to produce a period of higher than target inflation and achieve their target on average.
So the question for us is, what does this mean for front end rates going forward? Well, over the past three years, the Bureau of Economic Analysis’s headline personal consumption deflator averaged approximately 1.7%, with recent prints closer to 1%. To offset that, the next three years would need to average approximately 2.3% starting right now to achieve that 2% average target over a six year period. Because of this, our view is the Fed is likely to maintain their near-zero interest rate policy until at least 2023, and possibly longer. That should keep the US Treasury curve out to (at least) the 3yr point low and flat, which gives our team comfort in owning more duration in portfolios than we have in the past.
But with Treasury rates so low, we don’t see much value in owning that sector, at least not in large size. Instead, we have been running a longer position in short term credit, primarily via investment grade corporate bonds. The third quarter was generally favorable to short term credit with gains broadly across sectors. Spreads in July and August ground tighter, continuing the positive tone after retracing much of their dramatic March widening in the second quarter. But with some credit spreads nearing all-time tights over the summer, record new investment grade supply for a month of September, and quarter-end constraining dealer balance sheets, we did see modest widening of spreads in September, though not enough to undo all of the tightening from July and August.
Our team’s view coming out of our monthly investment policy meeting in early September was that we were likely to see volatility as we move towards the US election, and for this reason we had begun to pare back risk early in September prior to spreads widening meaningfully. We maintain the view that the uncertainties of the fall season could lead to more volatility as we work through continued re-openings of the economy including schools, rising COVID cases, the politicization of the next stimulus package, and the aforementioned US election which could lead to a protracted contest leaving the results hanging in the balance. For these reasons, we are cautious on adding back the risk we reduced in September. However, we also continue see the strong technical demand of money coming into the space, searching for yield in high quality credits, as money market fund yields move ever closer to 0. And for that reason, we are constructive on short term investment grade credit over the medium term. Anecdotally, our ultra-short team here at JPMorgan saw our assets rise by approximately $10 billion during the quarter. And that demand, coupled with the Fed’s support of the corporate credit market, should limit volatility and spread widening over the longer term. So, while we have reduced risk modestly for reasons mentioned, we will look for opportunities to add back that risk at cheaper, targeted re-entry valuations. This will help us to maintain our yield (and total return) advantage over money market funds at levels attractive for clients looking to take the next step out of cash to pick up incremental return.
Should you have questions or wish to speak, please do not hesitate to contact your JPMorgan Asset Management Representative who would be happy to put you in touch with us. In the meantime, thank you for joining the conversation, please take care of yourselves and stay healthy and safe.
Quarter in review: China’s economic recovery persists
Welcome to J.P. Morgan Global Liquidity’s audio commentary. My name is Aidan Shevlin, I’m the Head of the Asia-Pacific Global Liquidity Fund Management Team, and today I’ll discuss China’s economic and interest rate developments in the third quarter and the outlook for the rest of 2020.
With the Covid outbreak remained under control during the quarter, three factors dominated market and policy makers’ attention: the sharp, but uneven rebound in economic growth, the future path of People’s Bank of China (PBoC) monetary policy and the potential fallout from escalating US and China political tensions.
Let’s looking at these three factors in turn:
In mid-July, China reported strong Q2-2020 GDP numbers, with the economy rebounding by 11.5%y/y from last quarter’s record low. Traditional sectors, including manufacturing and property, as well as new sectors including e-commerce and internet, led the recovery but domestic consumer demand and services, which account for a significant part of the economy, remained muted.
Robust domestic and international demand for electronics and personal protective equipment was visible in industrial production, while fixed asset investments and infrastructure benefited from government stimulus. However, social distancing rules and employment uncertainty continued to weigh on consumer demand with retail sales lagging.
By the end of the quarter, industrial production and fixed asset investments had rebounded to year-to-date highs, while the easing of social restrictions and recovery in middle class spending triggered a revival in retail sales, which recorded the first positive reading since December.
Finally, inflation continued to decline from its first quarter peak of 5.4%y/y to a 17-month low of 2.4%y/y, although food prices remain expensive, with falling headline rate benefiting from a high base effect.
With the economy improving, PBoC monetary policy remained neutral throughout the third quarter, as the central bank focused on maintaining stable interest rates and adequate market liquidity. Key interest rates including the Medium Term Lending Facility and the Loan Prime Rate remained unchanged throughout the period.
Instead, the PBoC used liquidity injections via open market operations to influence market driven interest rates. During July and August, the PBoC withdrew liquidity, but as government, local government and policy bank bond issuance increased, market liquidity tightened, forcing the central bank to inject liquidity in September by holding larger repo and medium term funding operations.
Interest rates continued to trend higher throughout the period with SHIBOR yield increasing by approximately 50 to 70bps across the curve, they are now almost back at start of year highs. The 1-year treasury bills and 1-year policy bank bond also increased by a similar amount while 7-day interbank and stock exchange repo rates remained relatively stable, trading in a tight range between 1.4% and 2.8%. The Renminbi was the best performing Asian currency, appreciating by over 4.5% during the quarter, with the currency increasing to a 16-month high of 6.75 versus the USD by mid-September.
US-China political tensions escalated during the quarter with technology companies and the South China Sea emerging as key points of contention. Nevertheless, trade talks improved with China buying more US agricultural products and US imports of Chinese goods increasing sharply. By September, China’s exports had rebounded by 9.5%y/y to a seventeen-month high, while exports to the US jumped by 20%y/y as China has benefited from strong developed market demand for electronics, medical equipment and protective equipment.
In conclusion: by the end of the third quarter, the Chinese recovery from its first quarter Covid-19 shock was well established with economic data stronger than expected. Government supported sectors and exports continue to lead the rebound in activity, but even laggards like domestic consumption and services have started to normalize.
Although elevating US-China political tensions and concerns about the true strength of domestic demand remain a risk, the strong economic rebound and successful virus containment strategy implies China is likely to be one of the few large economies to report positive growth in 2020.
It has also reduced the probability of further monetary policy easing, with the PBoC likely to retain its neutral monetary policy stance for the remainder of this year. The central bank will remain focused on ensuring adequate and reasonable market liquidity while closely monitoring property and shadow banking sectors - suggesting interest rates will remain broadly unchanged for the foreseeable future.
Thank you for joining the conversation. Should you have any questions, please reach out to your J.P. Morgan Asset Management representative.
Principal stability, one of the main objectives of money market funds, is easily identifiable through the Net Asset Value prints or NAVs. Both Institutional Treasury and Agency Funds and Retail Funds continue to hold Stable NAVs, while Institutional Prime and Municipal Funds NAVs float around 1 dollar, rounded to the 4th decimal place.
Since the inception of Floating NAVs or FNAVs, movements have generally been incremental and slow; if Overtime, we’ve seen the FNAVs of institutional prime funds deviate a few bps on either side of a dollar, but we ultimately view the natural state of Institutional Prime funds FNAV’s to reside +/- 1 bp on either side of 1 dollar given the short duration profile and general low price volatility of the underlying assets.
Over the last few months, due to increased market volatility related to COVID-19 and Fed related moves, the industry has seen peak to trough movements exceeding almost 30bps in some funds. At the height of the volatility, the industry saw FNAVs in the low 9980’s, or about 20bps below the natural state of a dollar NAV. With Prime FNAVs elevated leading into the shutdown, in some cases above 1.0010, the actual decline was larger. It’s important to note that not all funds printed FNAVs in the 80’s, and not only did industry FNAVs quickly return to their natural state, but they have since rallied back above 1.0010 or 10 bps above a dollar, in some instances.
So, if historically FNAV movements have been incremental and slow, what drove this volatility?
During March, the Fed reduced rates 150bps to the lower bound of 0-25bps in response to the COVID-19 outbreak. At the same time, redemptions were occurring in the prime money market space. Remember-this was a liquidity driven event and was unrelated to specific credit concerns. Institutions wanted to ensure they had enough cash to weather the shutdown. With this in mind, and with a focus on liquidity, prime money markets were not adding to term positions. However, because certain institutions still required term funding, term money market levels increased. As yields widened relative to that of like securities held in money market portfolios, FNAVs began to fall, reaching their nadir around mid-March.
The Fed soon intervened with multiple facilities as a means to inject liquidity into the market. One program, the money market mutual fund liquidity facility or MMLF, had the largest impact on the prime money market space. This facility allowed banks or dealers to purchase U.S. Issued CP and CDs of highly rated issuers, and Tsys and GSE securities from 2a-7 funds, which they could then pledge as collateral to the fed for a non-recourse loan, or one that does not have any balance sheet implications.
Once the fed intervened, liquidity quickly returned to the market, assets began to flow back into the prime money market space, and prime money markets funds began to once again buy term securities out the curve. The effect on the portfolio FNAVs was twofold. As demand increased, yields decreased, which helped raise the funds FNAVs from their lows. Ultimately, as yields narrowed relative to like securities held in portfolios, the pricing of those positions increased, and helped to raise the FNAV of the fund. Additionally, as funds added term securities and yields continued to decline, those newly added positions were then quickly priced higher, resulting in an immediate upward impact on the FNAV of the underlying fund.
In the end, general market volatility did lead to some short-term relative volatility in the FNAVs of prime money market funds. However, FNAVs quickly returned to pre-shutdown levels. Overtime, as higher legacy positions roll off of portfolios and are reinvested closer to market levels, we anticipate Fund FNAVs to return to their natural state of a bp on either side of a dollar, thus continuing to realize one of their main objectives of principal stability.