In recent years, U.S. money market fund (MMF) yields fell precipitously to very low levels. Even after the December 2015 quarter-point rate hike, the federal funds rate resides in the Federal Reserve’s (Fed’s) target range of 0.25 percent to 0.50 percent. With the impact of upcoming regulatory changes, possible pressure on yields for treasury and government securities, and the demand for high-quality liquid assets, investors are asking if they should be concerned about the potential impact of negative rates on money market funds.
From 1980 to 2008, 10-year yields averaged 4 percent to 6 percent, with a high of 18 percent in the 1980s and a low of 1 percent in 2004–2005. This broad range gave the Federal Reserve plenty of room to maneuver during periods of economic weakness, and they accordingly reduced rates to stimulate spending and investment. While Fed Chair Janet Yellen doesn’t currently appear to believe the U.S. will need to follow Europe and Japan down the path to a negative interest rate policy, she hasn’t ruled it out. This raises the question:
What would negative interest rates means for U.S. Money Market Funds if they occur?
For the answer, we can look across the pond to see how our European neighbors have managed negative interest rates over the past several years.
In Europe, the money market fund industry has proven to be quite resilient to interest rates that have stayed below zero for some time. In 2009, Sweden’s Riksbank became the first central bank to use negative interest rates to bolster its economy.
Since then, the European Central Bank (ECB), Danish National Bank and Swiss National Bank have all followed suit. In the case of the ECB, it has supplemented interest rate cuts with bond purchases that have pushed rates further into negative territory in a bid to spur commercial banks to lend more money.1
To date, the money market industry in Europe adroitly adjusted to the negative rate environment through a couple of countermeasures.
CERTAIN MONEY MARKET FUNDS OPTED TO WAIVE THEIR FEES FOR A TIME TO KEEP RETURNS POSITIVE.
Some have elected to take a more drastic step by instituting reverse distribution mechanisms to maintain their funds’ stable share price. 2Traditionally, money market funds accrue income daily and distribute it to investors on a monthly basis in the form of new shares. Under the mechanism utilized, the process is reversed on days that yields are negative, meaning shares are canceled instead of issued. This effectively keeps the net asset value at $1 per share and precludes the fund from having to reflect a negative return.
While the environment remains challenging for MMFs operating on the continent, conditions appear to have stabilized, as assets in prime euro funds have increased so far this year. 3The industry’s experience has been in stark contrast to Japan’s, where the introduction of negative rates in January 2016 prompted all 11 companies that operate MMFs in the country to stop taking new investments and start returning money to investors.4
We also believe the resilience shown by European MMFs reflects the soundness and validity of MMFs compared with other short-term investment types such as bank deposits, certificates of deposit and direct investments. Most of these competing products cannot match MMFs in delivering daily liquidity, a key feature that continues to stoke demand from institutional investors. We believe investors will continue to invest in money market funds for the liquidity they provide and because shareholders benefit from a professionally managed, well-diversified portfolio of short-term securities. In addition, many MMFs continue to carry AAA ratings from the national recognized statistical rating organizations (NRSROs). Such ratings meet the investment policy requirements for select institutional investors, an achievement time deposits cannot match in the current environment.
EVEN AFTER DECEMBER HIKE, LITTLE ROOM TO MANEUVER ON RATES
Source: For Treasury GCF Repo, Depository Trust & Clearing Corporation (DTCC); for Federal Funds, Federal Reserve Bank of New York; for Eurodollar, Bloomberg.
Same Story, Different Continent
We believe the U.S. money market fund industry will follow a similar course as Europe and remain viable even if the economy slows and the Fed is forced to move interest rates below zero.
In testimony before the Senate Banking Committee5 in February 2016, Yellen said the Fed is studying the feasibility of pushing short-term interest rates below zero should the economy need an additional boost. Acknowledging that a "lot has happened" since the December 2015 rate hike, Yellen said the Fed was taking another look at negative interest rates after considering such a policy move in 2010.
Further proof that it’s serious about a negative-rate scenario came in the Fed’s latest annual stress test of major banks,6 in which it asked the firms to assess the impact a sharp rise in unemployment and a rate of -0.5 percent on short-term Treasury bills would have on their balance sheet.
Importantly, Yellen noted in her February testimony that rates on Treasury bills could go negative even in the absence of a policy shift by the Fed, as has happened on a few occasions in the past.
If that occurs, MMFs can look to their own recent past for precedent. Many MMFs waived fees in the aftermath of the 2008 financial crisis to keep their fund yields above zero while the Fed waited for strengthening in the economy. According to Peter Crane, president of Crane Data LLC in Westborough, Mass., the U.S. MMF industry was recognizing about $9 billion in revenues per year before the 2008 financial crisis but the institution of fee waivers in its aftermath dropped the annualized total to less than $4 billion by the close of 2013. Revenues have since recovered in part but remain less than $7 billion on an annualized basis. The Fed’s 25 basis points rate hike in December brought some much-needed relief to the industry, prompting most MMFs to begin reinstating a portion of or all of their fees.
Even if the Fed were to retrace its steps and reduce rates below zero, it would not be unexpected to see mutual fund sponsors waive some of their management fees to remain competitive. Depending on the severity and durations of the cuts, it may be necessary for MMFs to institute reverse distribution mechanisms similar to those adopted in Europe.
Sorting Out the Logistics
Of course, such responses will take some logistical groundwork. There’s a big difference between rates that are slightly positive and those that go negative, and the industry will likely need to take additional steps this time around if rates do in fact go below zero.
Fund companies, investment advisors, banks, transfer agents, fund custodians and U.S. Treasury officials are already in the process of programming and testing their systems to ensure negative interest rate postings can occur seamlessly, per the new regulatory stress tests.
While larger fund companies likely have the scale and resources to pass these tests, it may be that smaller funds simply let their returns go negative for a while or decide the investment isn’t worth it and close. One rule change on the horizon may make their decision easier.
While many in the industry once approach-ed the rule change with trepidation, the reality now is that many are prepared for a floating NAV and may simply rely on the new calculations to absorb the impact of negative interest rates.
As unhappy as the investing public is likely to be about negative interest rates after such a prolonged period of barely positive returns, we believe MMFs — particularly the larger funds that most investors rely on — are well-prepared for this scenario. We feel it will take more than negative rates to prevent MMFs from continuing to provide investors with short-term investments that consistently deliver market-rate returns, diversified credit risk and daily liquidity.