Fixed Income Strategy Mixed Messages in Money Markets | March 2019 - - PowerPoint PPT Presentation

Fixed Income Strategy

Mixed Messages in Money Markets | March 2019

Margaret Kerins, CFA Global Head of FICC Macro Strategy Margaret.Kerins@bmo.com 312-845-2687

1

Top Seismic Shifts Impacting Money Markets

Bank Regulatory Changes Money Market Reform Fed Balance Sheet Normalization Treasury Issuance Increases Corporate Repatriation Fed End B/S Runoff

Jan 2015 Oct 2016 Oct 2017 Nov 2017 Dec 2017 2H: 2019

 Supply and Demand Channel - Pull and push between large amounts of cash being put to

work and the supply of investment alternatives in money market space

2

Federal Reserve Intervenes to Keep Control of Target Rate

Fed Pays IOER to regain control over effective rate Fed Reverse Repo Facility Mops Up Excess Cash Fed to End B/S Rundown Sooner than Expected Possible Fed Repo to Mop up Excess Collateral

3

Seismic Shift #1: Bank Regulatory Reform

 Supplementary Leverage Ratio (SLR) - Tier 1 Capital to Total Leverage

• Low risk assets have the same capital charge as higher risk, higher yielding assets
• Impacted broker dealers as they hold a large amount of low-risk assets
• Increased the cost of balance sheet intensive products – repo
• Repo balances declined dramatically
• Decrease in repo available as an asset class pushed investors to increase bill

allocations

• Timeframe – finalized in 2014, public disclosure 2015, implementation 2018

Source: BMO CM, Federal Reserve Bank of NY

4

Seismic Shift #1: Bank Regulatory Reform

Source: BMO CM, Federal Reserve Bank of NY, Bloomberg

1,900 2,000 2,100 2,200 2,300 2,400 2,500 2,600 2,700 2,800 2012 2013 2014 2015 2016 2017 2018 Feb-19 $Bn BD Repo

BD Repo Balance Fall due to Reform Repo Rates & Bills Yields

• 20
• 15
• 10
• 5

5 10 15 20 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 BP GCF Repo - Fed Funds 20D MA 3M Bills - 3M OIS 20D MA

5

Seismic Shift #1: Bank Regulatory Reform

 Liquidity Coverage Ratio (LCR)

 Banks required to hold large buffers of liquid

assets to survive 30 days of funding stress

 Increased demand for high quality liquid

assets (reserves & Tsy)

0% 5% 10% 15% 20% 25% 30% 0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 % $ trillion US Banks - HQLA (estimated) HQLA as % of Total Assets

Bank High Quality Liquid Asset Demand

Source: BMO CM, Federal Reserve Bank of NY

6

Seismic Shift #2: Money Market Reform

500 1,000 1,500 2,000 2,500 3,000 3,500 2014 2015 2016 2017 2018 $Bn Govt Prime Tax-Exempt

Shift from Prime & Tax-Exempt to Gov’t MMF Holdings – Chg 2014-2018

441 245 358

• 511
• 156
• 600
• 400
• 200

200 400 600 $Bn UST Total US Agy Total Repo Total CD/CP Muni

 Floating NAV, gates & fees for non-gov’t = Shift out of prime and into Govt MMF

Source: BMO CM, ICI

7

Implications of Money Market Reform

 Increased MMF demand for short Treasuries, agencies and repo = oversupply of cash

seeking eligible investments – decreased repo rates and bill yields

 Fed RRP Facility –mopped up the excess supply of cash seeking a home

Source: BMO CM Bloomberg

• 25
• 20
• 15
• 10
• 5

5 10 15 20 25 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 BP SOFR - Fed Funds 4wk MA 3M Bills - 3M OIS 4wk MA

50 100 150 200 250 300 350

• 20
• 15
• 10
• 5

5 10 15 20 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Jul-17 Sep-17 $Bn BP Domestic RRP 20D MA Zero SOFR - Fed Funds 20D MA

8

Money Market Reform Update

 Proposal to reverse some portions of money market reform

• Floating NAV increased borrowing costs for municipal borrowers - large decrease in tax exempt

money market funds holdings forced municipal borrowers to issue higher cost fixed rate securities

• Many state and local governments can only invest in stable NAV money funds, so money market

reform forced them into lower yielding US government funds

 Allows MMFs to elect to use the stable NAV approach instead of floating NAV to

calculate their share price and to choose not to be subject to the mandatory liquidity fees

 Status – introduced but not enacted, bill died in the previous Congress

9

Seismic Shift #3: Heavy Treasury Issuance

 Net Tsy supply >$1 trillion per year

– Deficits – Replacement Needs due to Fed B/S rundown – Basically, prior Fed purchases had financed some part of the prior deficits. The amount of SOMA runoff has to be refinanced into the public markets.

 Heavy Coupons and Bills

– Holds current coupon auction sizes constant, so the funding difference is made up with net bill issuance. – Therefore, auction size increases are likely in 2021 at current deficit projections unless Fed starts buying bills.

Source: BMO CM, CBO, Treasury

Heavy Net Treasury Issuance Set to Continue

• 1,400
• 1,200
• 1,000
• 800
• 600
• 400
• 200

200 400 600 800 1,000 1,200 1,400 1,600 2015 2016 2017 2018 2019 2020 2021 Deficit (Inverted) $Bn $Bn Net Cpn Issuance Net Bill Issuance Deficit

10

Treasury Supply – Front-End Weighted

Source: BMO CM, CBO, Treasury 200 400 600 800 1,000 1,200 1,400 1,600 2s, 3s, 5s 7s, 10s, 30s 2yr FRN TIPS $Bn Total at Jan 2018 Size Total YE 2018 Total YE 2019 20 40 60 80 100 120 140 160 180 2 3 5 7 10 30 2yr FLT $Bn Chg 2018 Chg 2019 Chg

Gross Issuance by Term Bucket Issuance Increase from Auction Size Change

11

Impact of Heavy Treasury Issuance

 Increased bill supply pressured bill yields higher vs. fed funds

Source: BMO CM, Treasury, Bloomberg

• 20
• 15
• 10
• 5

5 10 1.50 1.60 1.70 1.80 1.90 2.00 2.10 2.20 2.30 2.40 2.50 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 Feb-19 Mar-19 BP $Bn Bills Outstanding 3M Bills - 3M OIS 20D MA

12

Impact of Heavy Treasury Issuance

 Periods of crowding out from Treasury Debt

 Increased bill supply crowds out other money market investments  Increased coupon supply increases collateral, pressuring repo rates higher

Source: BMO CM, Treasury, Bloomberg

Q1:18 Heavy Bill Issuance Cheapened Front-End Heavy Coupon Supply Increases Repo Rates

• 20
• 15
• 10
• 5

5 10 15 140 190 240 290 340 390 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 Jan-19 SOFR- Fed Funds BPs PD Positions $Bn Avg PD Positions SOFR- Fed Funds

10 20 30 40 50 60 70

• 200
• 100

100 200 300 400 500 600 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 Jan-19 SOFR- Fed Funds BPs PD Positions $Bn Rolling 6M Bill Issuance LOIS

13

How Does Bill Supply Crowd Out?

 Government MMFs fill up on the highest

yielding assets first to the degree that they are available.

 They reallocate based on relative richness

and cheapness in the marketplace within WAM goals.

 Their main asset classes are UST, US Agy

and Repo.

 Increases and decreases in AUM impact the

net demand for each asset class.

Source: BMO CM, ICI, Bloomberg

Gov’t MMF Asset Allocation

550,000 600,000 650,000 700,000 750,000 800,000 850,000 900,000 950,000 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 Jan-19 $Million UST US Agy Totl Repo

14

How Does Supply Crowd Out Impact Relative Yields?

 In Feb 2018 gov’t MMF shifted into bills absorbing heavy issuance. They continued to increase bill

holdings while decreasing agencies and repo as AUM declined. 3M bills moved higher than 3M OIS and repo rates moved higher than fed funds. We can also see the impact of heavy coupon supply on repo.

Source: BMO CM, ICI, Bloomberg

Gov’t MMF Asset Allocation Change Relative Money Market Yields

• 200,000
• 150,000
• 100,000
• 50,000

50,000 100,000 150,000 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18 Dec-18 Jan-19 $Million UST US Agy Repo Total portfolio securities

• 25
• 20
• 15
• 10
• 5

5 10 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 BPs SOFR- Fed Funds 3M Bills - 3M OIS

15

 Excess collateral in system increases demand for repo financing pressuring money

market yields higher all else equal

 Record levels of Treasury supply may crowd out other money market funding sources,

increasing yields across the sector (basically, everyone else funds after Treasury, so higher Treasury yields mean higher yields for all other borrowers)

 Fed is likely to respond with a repo facility to mop up the excess collateral

S

Implications Heavy Treasury Supply

16

Seismic Shift #4: Fed Monetary & Operating Policies

 In 2008, the Fed created a new, risk-free earning asset when it began paying

interest on excess reserves.

 Paying interest on excess balances was done to help to regain control over the

federal funds rate.

 This was especially important when reserves expanded during the financial crisis

placing extraordinary downward pressure on the fed funds rate.

Source: BMO CM, Bloomberg

17

Fed Paying Interest on Reserves

 As reserves increased, the Fed lost control of the effective rate. In Oct 2008, they started paying interest

• n reserves, but the initial rate failed to get the effective rate under control, so they experimented a few

times until the effective rate neared the target rate. There was substantial volatility in money market rates during this period.

Source: BMO CM, Bloomberg 200 400 600 800 1,000

• 100
• 75
• 50
• 25

25 Aug-08 Aug-08 Sep-08 Oct-08 Oct-08 Nov-08 Dec-08 Dec-08 Jan-09 Feb-09 Feb-09 Mar-09 $Bn BP Fed Funds Eff less Upper Bound 20d MA Fed Reseve Balances

• 120
• 100
• 80
• 60
• 40
• 20

20

• 0.50
• 0.25

0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 BP Yield % 3m Bills 3M Bills - 3M OIS 20D MA

18

Fast Forward to Fed Balance Sheet Normalization

 The Fed started shrinking its balance sheet in Oct 2017, removing reserves from the system. This

pressured fed funds effective higher – closer to the top end of the range. 3M Bills yields had been trading well below 3M OIS (proxy for term funds), but are now trading above the effective funds rate. Some of this is supply related.

1,500 1,600 1,700 1,800 1,900 2,000 2,100 2,200 2,300 2,400 2,500

• 20
• 18
• 16
• 14
• 12
• 10
• 8
• 6
• 4
• 2

Oct-17 Dec-17 Feb-18 Apr-18 Jun-18 Aug-18 Oct-18 Dec-18 Feb-19 $Bn BP Fed Funds Eff less Upper Bound 20d MA Fed Reseve Balances

Source: BMO CM, Bloomberg

• 30
• 25
• 20
• 15
• 10
• 5

5 10 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 BP 3M Bills - 3M OIS 20D MA Zero

19

Fed Responds – End Balance Sheet Normalization

 The decline in reserves coupled with the fed funds rate trading near the top of the range

sparked concerns that reserves may fall below minimum bank demand. If this happened, some banks could find themselves short of reserves and have to borrow in the unsecured

• vernight markets, pressuring yields substantially higher than the fed funds rate.

 The Fed responded by changing its monetary policy operating framework to one with ample

reserves to meet bank demand (January 2019). End B/S runoff.

 This results in high excess reserves to meet bank demand and lower Treasury bill issuance

in the near-term as Treasury no longer has to replace runoff.

20

Problems Still Exists

 There is still too much collateral (Treasuries to be financed) in the system relative to the

demand.

 Fed has been lowering IOER within the target range to keep fed funds from rising above

target range, and fed funds now trading on top of IOER.

 Potential Fed Action

• Continue to reduce IOER relative to the target rate – could happen without any changes to the upper

bound.

• Fed may implement a standing repo facility to address problem of excess collateral
• Fed may buy bills once the balance sheet begins to grow again – which would probably coincide with

increased Treasury issuance needs

21

Fed Monetary Policy & Intervention Actions - Implications

 Increase stability in money markets as reserve scarcity episodes become less

likely

 Lower bill supply should reduce crowding out episodes  Lower and less volatile money market yields on a relative basis

22

Seismic Shift #5: Corporate Repatriation

 Freed up foreign profits  Profits were held in USD investments  Largest holdings = corporate and Treasury securities

23

Corporate Repatriation

1.

Reduced demand for these assets

2.

Portfolio shedding added supply into the market as investment portfolios fell by $150bn to $600 bn since Q3:17

3.

Results in choppy demand for money market products

– Sell securities from investment portfolio = credit wider spreads – Park in ST money markets = vol in money market yields, but depends on flow concentration – Distribute to shareholders Decrease in Corporate Investment Holdings

Source: BMO CM, SEC Financials for Largest 10 Repatriated Portfolios

• 70
• 60
• 50
• 40
• 30
• 20
• 10

2018 Chg $Bn Money Funds CP/CD/Time Cash & Cash Equiv US Govt & Agy US Corporates

24

Summary of Mixed Signals in Money Markets

1.

Treasury bill and coupon issue will continue to increase dramatically

2.

Fed is likely to intervene to control the fed funds rate, adding stability to the marketplace.

3.

However, sporadic periods of disequilibrium in the supply and demand channels will continue to result in periods of market volatility

25

These materials are confidential and proprietary to, and may not be reproduced, disseminated or referred to, in whole or in part without the prior consent of BMO CM (“BMO”). These materials have been prepared exclusively for the BMO client or potential client to which such materials are delivered and may not be used for any purpose other than as authorized in writing by BMO. BMO assumes no responsibility for verification of the information in these materials, and no representation or warranty is made as to the accuracy or completeness of such

• information. BMO assumes no obligation to correct or update these materials. These materials do not contain all information that may be required to evaluate, and do not constitute a

recommendation with respect to, any transaction or matter. Any recipient of these materials should conduct its own independent analysis of the matters referred to herein. “BMO CM” is a trade name used by BMO Financial Group for the wholesale banking businesses of Bank of Montreal, BMO Harris Bank N.A. (formerly Harris N.A.) and Bank of Montreal Ireland p.l.c, and the institutional broker dealer businesses of BMO CM Corp. and BMO CM GKST Inc. in the U.S., BMO Nesbitt Burns Inc. (Member – Canadian Investor Protection Fund) in Canada, Europe and Asia, BMO Nesbitt Burns Securities Limited (registered in the United States and a member of FINRA), BMO CM Limited in Europe, Asia and Australia and BMO Advisors Private Limited in India. BMO does not provide tax or legal advice. Any discussion of tax matters in these materials (i) is not intended to be used, and cannot be used or relied upon, for the purposes of avoiding any tax penalties and (ii) may have been written in connection with the “promotion or marketing” of the transaction or matter described herein. Accordingly, the recipient should seek advice based on its particular circumstances from an independent tax advisor.

Disclaimer

DISCLAIMER

All values in this document are in C$ / US$ / A$ / € / £ / ¥ / ₹ unless otherwise specified