Understanding zero interest ratesContributor Kyongsoo Noh
- Zero interest rate policy, a Federal Reserve (Fed) tool for stimulating the economy, has brought money market fund yields closer to zero by lowering the yield on the ecosystem of high quality, front-end fixed income products.
- We anticipate extraordinary monetary policy should remain in effect until the U.S. recovers from the pandemic’s economic effects, which will likely take some time.
- Although government money market fund yields are nearing 0%, we don’t expect they will go negative. Nor do we expect, at this time, the Fed to implement negative interest rate policy in the foreseeable future.
- Prime money market funds (MMF) are an alternative option for liquidity investors that want a spread over government MMFs and can tolerate a modest amount of incremental risk. For those who do not need a MMF solution, ultra-short strategies have a little more risk and return than prime MMFs.
In response to the Covid-19 pandemic, the Federal Reserve (Fed) implemented a comprehensive package of actions to stimulate growth and stabilize financial markets. One of the most prominent components of the package was zero interest rate policy (ZIRP), a monetary tool that lowers the cost of capital in the system.1 While ZIRP is necessary and justified during the current economic downturn, the resulting lower interest costs come at the expense of savers including, of course, money market fund investors. Clearly, ZIRP will have a lasting effect on this economic cycle—and on cash investors. We examine how ZIRP works, its impacts, likely timeframe, whether we expect rates to go negative (spoiler: we don’t) and options available to liquidity investors.
What does ZIRP mean in the U.S.?
Let’s step back and examine the rate we’re talking about. In the U.S., the main benchmark rate for monetary policy is the federal funds (fed funds) rate, which is not actually set at an exact percent level but targeted within a range. ZIRP in the U.S. means the Fed has set the lower bound of the fed funds target range to 0.00%. Today, the target range for the fed funds rate is 0.00% to 0.25%.
What exactly is the fed funds rate?
Banks must maintain a minimum amount of reserves (or readily available cash either in paper or electronic form) against their demand deposits to safely meet withdrawals or, in extreme cases, to prevent bank runs. The minimum amount of reserves is determined by bank regulators. If a bank has less than the required reserves, it has to borrow them. The fed funds rate is the interest rate a bank pays to borrow reserves. It can borrow them from a bank that has excess reserves and is willing to lend them. Alternatively, it can borrow cash for reserves purposes from government sponsored enterprises (GSEs).2 The Fed aims to have all these fed funds transactions price within the fed funds target range.
Banks also often raise cash for reserves purposes by borrowing on a secured basis in the repurchase agreement (repo) market. While repo trades are not technically fed funds transactions, repo backed by government bond collateral (GC repo) generally trades within the fed fund target range, and is also affected by the amount of cash that is readily available in the banking system. We will talk a little more about GC repo later in this piece.
How does the fed funds target range define money market funds’ investing ecosystem?
A bank with excess reserves can lend them into the fed funds market but it does not have to do so. It has other choices. That bank may make loans, underwrite mortgages or buy other risk assets. A safer, more liquid option is buying U.S. Treasuries (USTs) or GC repo. Alternatively, it may deposit excess cash at the Fed; these Fed deposits earn the interest on excess reserves rate (IOER), which is currently set at 10 basis points (bps) above the lower bound of the fed funds target range (0.10% today). If a bank decides to purchase USTs or GC repo, it competes directly with government money market funds (govie funds) for those investments.
The GSEs are both lenders (into the fed funds market) and borrowers (in the agency discount note [disco] and agency debenture markets). The fed funds market drives the pricing of these securities, and govie funds are big buyers of discos in particular.
Now let’s shift from govie funds to prime money market funds (prime funds), which invest mostly in bank commercial paper (CP) and certificates of deposit (CD). We know that banks can borrow reserves from one another in the unsecured overnight interbank market. From a fundamental credit standpoint, a fed funds transaction between banks is very similar to banks selling unsecured overnight bank CP or CDs—with one major difference: fed funds between banks are traded in the interbank market while CP and CDs are traded from banks to investors in the securities markets. Regardless of the difference, issuers of overnight bank CP and CDs are indirectly competing with banks that need to borrow reserves. Since overnight and weekly CP and CDs are staple holdings in prime funds, the fed funds target range heavily influences that portion of prime portfolios.
The takeaway: The fed funds target range defines a whole ecosystem of front-end yields that have a great bearing on money market fund investing, both govie and prime.
Didn’t the Fed just change banks’ reserves requirement to zero? Does that mean the fed funds target range is moot?
Although the Fed did reduce the reserve requirement to zero (announced March 15) as part of its pandemic support programs, it did not make reserves unnecessary, nor did it make the fed funds range moot. Because banks need cash to operate, and because banks remain subject to other capital and liquidity requirements, well-run banks will still maintain prudent levels of reserves, regardless of the change in reserve requirements. The change just means that all reserves are considered excess reserves for the time being, and therefore reserves are plentiful in the banking system.
When reserves are plentiful, banks and investors need to put that money to work. This demand drives yields down and therefore, shorter maturity USTs, GC repo, discos as well as overnight bank CP and CDs will typically trade at the lower end of the fed funds target range. That is what we are seeing today. (When reserves are scarce, the opposite is true—borrowers drive yields up and these investments tend to trade towards the upper part of the fed funds target range.)
What is forward guidance and how is it affecting front end rates?
Forward guidance is the communication by a central bank about future monetary policy in the context of the economy. In this monetary easing cycle, the Fed has issued forward guidance that it will keep ZIRP in place until the U.S. recovers from the negative economic effects of the pandemic. Because of that forward guidance, the yield curve has flattened. Three-year UST yields are trading under 0.22% (as of May 19, 2020), implying that the market expects ZIRP will be in place for the next three years. Even within the Treasury bill (T-bill) curve, yields from 3 months to one year in maturity only range from 0.10% to 0.15%, which means that extending maturities does not pick up much yield.
How long did ZIRP last after the global financial crisis (GFC) and how long will it last this time? What might happen to net yields on govie funds?
During and after the GFC, ZIRP lasted for seven years, from 2008 to 2015. Forecasting exactly how long ZIRP will be in effect this time is difficult but one framework we can use to help answer this question is the Fed’s dual mandate: maximizing employment and maintaining stable prices.3 The unemployment rate in the U.S. is currently 14.7% and rising—a somber and staggering figure, the highest unemployment rate in the country’s history, outside of the Great Depression. At the same time, we also saw month over month inflation fall by 0.4% April due to a significant drop in economic activity as a result of the pandemic.4 While we do think inflation should get back to positive territory within a quarter or two, it will likely take years before we see the labor markets normalize. The employment issue is why we think ZIRP will last at least a few years.
Govie funds in the U.S. have never had negative net yields. During the last period of ZIRP, during and after the GFC, when gross yields on govie funds fell below the standard management fees on the funds, asset managers reduced their fees to make sure that net yields did not go negative. We believe that the govie fund industry will do the same during this new period of ZIRP.
Do we expect negative interest rate policy (NIRP) in this economic cycle?
Despite the advocacy of a small but growing chorus of proponents for negative interest rate policy in the U.S, we do not believe the Fed will implement NIRP in the foreseeable future. The upcoming election in November 2020, and the end of Fed Chair Jerome Powell’s term in February 2022, may change our view. But for now, Powell and Fed officials have stated that they prefer using other policy tools—additional quantitative easing (QE), forward guidance, yield curve control (YCC) and targeted credit purchases—over NIRP to deal with the economic downturn.
The Fed has reasons for saying so. Years of NIRP in Japan and Europe, in response to the GFC, coincided with a decade of low GDP growth rates in those regions. Examining those experiences, it is not clear whether NIRP encouraged significant incremental capital formation and economic expansion. Furthermore, NIRP discourages banks from holding excess reserves, which is not the right policy directive for some banks. To reiterate, we do not think the Fed will implement NIRP.
Let’s say we are wrong. If NIRP were implemented, which is not our base case, we believe the government would give the U.S. financial system ample time to adjust. We would need securities regulation, funds regulation and accounting policy changes and clarifications to allow for negative rates, particularly for the money market fund industry. Even using European NIRP as a blueprint, it would still take many months for U.S. market participants to make the necessary changes to implement the policy.
Finally, there is a difference between negative rates driven by policy and negative yields driven by market forces. In mid to late March of this year, we did briefly see T-bills trade at negative yields as the worst of market effects of the pandemic took hold. However, two components of ZIRP itself make it very difficult for negative rates to persist for long periods of time: the reverse repurchase program (RRP) and IOER. The Fed can sell repo, collateralized by USTs on its balance sheet, to money market funds at the lower bound of the fed funds target range (or 0% during ZIRP) – these trades are known as RRP. Also, remember that banks can invest excess reserves in deposits at the Fed and earn IOER (which is set at 0.10% today). Between RRP and IOER, portions of the market have significant amounts of investable assets at 0% yields or better, and that puts upward pressure on negative yields.
What does all of this mean for mean for govie funds?
- ZIRP has lowered the fed funds target range to 0.00% to 0.25%.
- The zero reserves requirement has moved yields on the ecosystem of high-quality front-end fixed income products to the lower part of the fed funds target range.
- Forward guidance has flattened the rates curve.
The upshot is that the investable universe of government-related front-end fixed income instruments is largely trading at 0.15% yields, or less, today. Because top-tier govie funds locked in higher yields over the past couple of months, they are yielding approximately 0.15% to 0.20%, net of fees, at the fund level. This is very attractive, relative to where bonds are trading today, but it is only a matter of time before net fund yields approach near 0.00% as govie funds reinvest maturities.5
If near 0% net yields are not appealing, what other options are there?
Before answering this question, I will highlight that the first time the Fed implemented ZIRP, near-zero net yields on govie funds were perfectly acceptable for many investors that prioritized the safety and liquidity that govie funds provide. When the GFC-related period of ZIRP began in December 2008, the volume of assets invested in govie funds was approximately $1.5 trillion. Eventually, as yields dropped, govie fund assets decreased and at one point fell to a local trough of about $740 billion.6 Although this is about half of what it was when ZIRP was first announced, it was still a very sizable amount.
We may see net yields on govie funds nearing zero as early as this summer – the move to near zero would likely be even faster if yields were not being supported by the elevated T-bill supply funding the Coronavirus Aid, Relief, and Economic Security Act (CARES) of 2020. With this in mind, now is an appropriate time to think about other liquidity investment options if yield is a consideration.
Due to ZIRP and forward guidance, there is very little slope to the front end rates curve. Therefore, govie fund managers cannot simply extend duration to avoid near 0.00% net yields in the near future. However, there is still some steepness in the front-end credit curves that prime funds can capitalize on for investors. If you can tolerate the modest amount of incremental risk of prime funds, they are an attractive option right now. Currently, top-tier prime funds are out-yielding govie funds by an average of 30 bps net of fees. If you have a little more risk appetite and do not require a money market fund solution, ultrashort funds are another choice. Reasonably conservatively managed ultrashort funds can typically outperform prime funds by about 20 bps to 40 bps on an annualized net return basis, and in the current environment by even more.
If you have any questions about zero interest rate policy or anything else, please contact your J.P. Morgan Global Liquidity Client Advisor.
1In addition to ZIRP, the Fed also implemented quantitative easing (QE) to further lower interest rates, increase bank liquidity and expand the monetary base; launched a number of purchasing programs for corporate, municipal and consumer credit to stabilize spreads and support capital market participation and eased regulation to enhance the ability of the banking system distribute risk and capital through the markets. We discussed which of these policies are most affecting the front end of the curve on our Global Liquidity Q2 Guide to the Markets broadcast; to hear a replay, https://am.jpmorgan.com/asset-management/gim/liq/gl-webcasts.
2 GSEs include Fannie Mae (the Federal National Mortgage Association, FNMA), Freddie Mac (the Federal Home Loan Mortgage Corp, FHLMC) and the Federal Home Loan Bank (FHLB) system. All manage tremendous amounts of cash daily to support their mortgage-related activities.
3 These were codified into law by the Federal Reserve Act (1913).
4US Consumer Price Index Urban Consumers Less Food & Energy Month-over-Month Seasonally Adjusted Index, Bloomberg, April 2020.
5 Typical fees for top-tier govie fund managers are 18 bps, but as mentioned earlier in this paper, govie fund managers will likely waive fees in order to prevent govie fund net yields from going negative.
6In August 2011 (Source: iMoneyNet)