In a global financial environment dominated by negative interest rates and central banks signaling even more accommodative policies, the U.S. money-market industry is thriving.

Normally seen as a place to park cash during times of uncertainty, taxable funds have seen roughly $136 billion of inflows this year, even with U.S. equity markets surging and bonds posting positive returns, Investment Company Institute data show. Overall assets have swelled to more than $3 trillion, the highest level since the financial crisis.

Demand is being aided in part by attractive U.S. short-term yields relative to bank deposits—helped by three years of Federal Reserve interest-rate hikes, an inverted yield curve, and volatility in financial markets. Total assets in government money funds are at a record high, and investments in prime funds are the most since September 2016, before industry reforms went into effect.

While the specter of Fed rate cuts is not perceived as an imminent threat, it will be a topic among attendees at the Crane's Money Fund Symposium in Boston beginning Monday. Other issues likely to come up include the drop in yields and narrowing spread between government and prime money-market funds, as well as the post-reform growth of the market for repurchase agreements and popularity of sponsored repo.

“Money fund yields are still above 2 percent, whether it's government or prime,” said Pia McCusker, the Boston-based global head of cash management at State Street Global Advisors Trust Co. “That's still attractive to investors today. If people are looking for a safe haven, cash is still a great place.”

The yield on two-year Treasuries have dropped almost 74 basis points, to 1.75%, this year.

The Fed Effects

Now that the Fed has scrapped the use of “patient” when describing its approach to monetary policy changes, derivatives markets are pricing in more than 25 basis points of easing at the next Federal Open Market Committee (FOMC) meeting in July. Yet fund managers are nonplussed, given that money rates are still more attractive than bank deposits. Historically, money funds tend to see outflows one to two years after the Fed cut rates, according to Alex Roever, head of U.S. rates strategy at JPMorgan Chase & Co.

After a series of risk-off events in 2007 and 2008 that pushed investors into money funds, the Fed cut interest rates to zero, which crushed money-market yields. Investors pulled cash from money funds in search of higher-yielding assets. “It wasn't the fact that they had to cut rates,” Roever said. “It's that the overall level of rates got so low in that scenario.”

Another issue that could arise is whether the Fed decides to introduce a tool to keep money-market rates under more control. Rates for repurchase agreements—a key component of short-term funding markets—have recently shown a tendency to spike around month-end, which has helped to pull the fed funds rate higher. Fed Chairman Jerome Powell said at his post-meeting press conference last month that the central bank will, at a future meeting, look at the idea of a so-called standing repo facility.

Impact of Lower Yields

Even as money funds remain attractive investment vehicles, the drop in yields will be a topic of discussion. After peaking at around 30 to 35 basis points in December, the spread between prime funds—which invest primarily in commercial paper, certificates or deposits and time deposits—and government funds has collapsed to around 20 basis points, according to State Street's McCusker.

Part of that is related to commercial paper issuance and where financial institutions are choosing to issue. So far this year, there has been an average 21 issues of AA rated CP longer than 81 days on a typical day, Fed data show. That is down from an average of 28 issues during the same period in 2018. This dearth of supply “bleeds through to LIBOR settings being lower and overall yield being lower on prime funds,” Roever said.

Given the growth in government money fund assets after the 2016 reforms were enacted, the repo market has expanded to keep up with the increased demand. Dealer repo with money-market funds has risen to $1.2 trillion as of the end of May, Office of Financial Research (OFR) data show. That's because of the growth in sponsored repo, which are transactions where dealers sponsor non-dealer counterparties onto Fixed Income Clearing Corporation's (FICC's) cleared repo platform. Last month, money fund cash invested in cleared repo jumped to a record $154 billion, according to OFR, up from about $5 billion in June 2017 when funds first started participating.

Barclays Plc strategist Joseph Abate expects sponsored repo volumes to grow, though “it's difficult to project how popular the program will become,” he wrote in a note published June 19. “How much single counterparty exposure to the FICC does a money fund wish to have? 25%, 50%, or more?”

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Money Markets Are Thriving in an Uncharacteristic Sweet Spot

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