Where can investors put cash to work when rates go negative?

Just when investors thought they couldn’t sink any lower, the economic shock caused by COVID-19 has put further downward pressure on interest rates in developed markets. Caroline Hedges, head of global liquidity portfolio management at Aviva Investors, looks at the impact on money market funds.

Where can investors put cash to work when rates go negative?

The global spread of COVID-19 has led to a sudden and unprecedented stalling of the global economy, prompting drastic action from central banks and governments around the world to limit the long-term impact of the pandemic. Yet while monetary easing has been significant, more may be needed to curb rising unemployment, deflationary pressures and a sustained recession. This will have significant implications for money market funds.

With interest rates already close to zero in the UK and the US, there is increasing speculation as to whether their respective central banks – the Bank of England and the US Federal Reserve (Fed) – will follow the euro zone, Denmark and Japan and take interest rates negative.

This makes it more challenging for companies to find yield on their short-term investments, as bank deposits typically offer no returns and yields on money market funds are declining. At the same time, ultra-low interest rates and government bond purchase schemes mean higher quality businesses can raise cash cheaply and position themselves to seize opportunities that may arise from the weaker economic environment, such as cheaper assets and land. However, until these materialise, companies are struggling to find places to put this cash that offer some form of return, while still keeping it readily available.

Figure 1: Total assets have picked up since March
Total assets have picked up since March
Source: Fitch Ratings, iMoneyNet. Data as of May 29, 2020

Will UK rates go negative?

Until recently, the likelihood of the Bank of England moving to negative interest rates for the first time in its 325-year history seemed extremely low. The Monetary Policy Committee (MPC) had always been vocal in its opposition to negative rates, with former governor Mark Carney stating the lower bound for interest rates was close to but above zero. As recently as May 14, governor Andrew Bailey reiterated the MPC was not considering negative interest rates.

Negative interest rates have had a positive effect in the sense of having a fairly powerful transmission to real activity

Since then, however, MPC rhetoric has changed markedly. Chief economist Andy Haldane said the bank was now looking more urgently at extending quantitative easing to buy riskier assets and the possibility of a negative bank rate.1 MPC member Silvana Tenreyro commented that “negative interest rates have had a positive effect (in Europe) in the sense of having a fairly powerful transmission to real activity”.2 And Bailey quickly changed tack on May 20, when he confirmed negative rates were “under active review”.3

Conversations at the central bank are likely to continue in the coming weeks as further economic data comes in and the risk of a second wave of the virus is assessed following the recent spike in Leicester. There may be some divergence in opinion between MPC members on the opportunity of moving below zero, adding to the uncertainty around future interest rate moves.

The change in rhetoric has driven erratic market pricing. Gilt yields have been oscillating between positive and negative territory as the demand for assets has spiked, but in May the government sold negative-yielding gilts (with a three-year maturity) for the first time, perhaps suggesting investors are resigning themselves to the idea of negative rates.4

It would be prudent to prepare for this eventuality, particularly if markets begin to price in further rate cuts, which could force the MPC’s hand into aligning with such expectations.

In fact, while talk of negative rates has subsided since late May, money markets remain awash with supply due to the bank’s bond purchase programme – expected to raise between £750 and £800 billion – thereby maintaining pressure on yields to stay low.5 One-month GBP LIBOR was nine basis points on June 30, with market forecasts teetering at slightly lower levels, making it difficult for investors to find higher-yielding assets in the UK money market.

Figure 2: UK OIS forward curve dropped below zero on May 22, 2020
UK OIS forward curve dropped below zero on May 22, 2020
Source: Fitch Ratings, Bank of England, Bloomberg. Data as of May 22, 2020

A risk of negative rates in the US

As the economic damage caused by COVID-19 became more apparent and the Fed implemented swift emergency measures, discussions on negative interest rates have also gained momentum in the US.

Fed Chairman Jerome Powell has stressed additional policy measures may be required to ease market stress and support the economy. However, he has also clearly stated that a negative policy rate is not something the FOMC is considering. Having discussed and ruled out the possibility in October 2019, officials have stated that their view has not changed.6

The Federal Open Market Committee (FOMC) did not make any additional policy changes at the April meeting, leaving the policy rate unchanged at a zero to 0.25 per cent target range. Nevertheless, by early May the futures market was pricing in a negative federal funds policy rate in 2021.

The FOMC emphasised that current policy would remain in place until the US economy was well on its way to a return to full employment

The FOMC emphasised they were not looking for a swift pull back from the unprecedented levels of accommodation, and that current policy would remain in place until the US economy was well on its way to a return to full employment (an unemployment rate of four to five per cent) and inflation close to its two per cent target. Powell also indicated the Fed remained ready to act if additional measures were required to ease credit conditions. Citing “considerable risks” to the economic outlook over the medium term, the statement signalled that the Fed does not expect a V-shaped recovery. 

One vocal supporter of negative interest rates is President Donald Trump, who has insisted that negative rates are a “gift” that policymakers should embrace. While Powell has resisted thus far, the Fed has at times responded to political pressure, for example cutting rates in 2019 after Trump called for it and markets were pricing the drop in. In late May, researchers at the St. Louis Fed also broke ranks, for the first time arguing in favour of negative rates.7

At the same time, however, analysts at many of Wall Street’s biggest banks, including Bank of America, Citi, Goldman Sachs and JP Morgan are not predicting negative interest rates. Despite the bank having expanded its balance sheet to a record $7 trillion through bond-buying programmes, some analysts argue the Fed has more attractive options to spur growth, and negative rates would be a last resort. Executives from banks like JP Morgan, Morgan Stanley and Goldman Sachs claim the benefits of negative rates to the economy are uncertain while the damage to the banking system is significant.8

While negative rates in the US may still be unlikely, they are not inconceivable in the coming years given the economic uncertainty – although the Fed will surely use the full power of its balance sheet and urge further fiscal support before considering this option.

Lessons from the euro zone

The euro zone illustrates what may happen in a long-term negative rate environment. Given the impossibility for euro money market funds to continue delivering positive returns after 2014, most were kept as variable net asset value (VNAV) funds when the European Union’s Regulation on Money Market Funds came into force in 2018.

Figure 3: Euro fund yields dropped below zero several months after rates went negative
Euro fund yields dropped below zero several months after rates went negative
Source: Fitch Ratings, iMoneyNet, ECB. Average yields of euro short-term MMFs. Data as of May 29, 2020

Money market funds that operate under the VNAV structure continue to float with a variable NAV that decreases in line with the negative rate on the fund, as well as any changes to the market value of the underlying assets. Although it means returns in these funds are negative, VNAV or LVNAV are the only sustainable structures for money market funds over a period of long-term negative interest rates.

As euro money market fund returns went negative, markets saw a ‘rush to zero’. Investors moved out of those funds and into other asset classes, such as ultra-short bond funds and even some unrated asset classes, looking to get, if not positive yield, at least zero on their cash, up from the negative 30 or 40 basis points on their money market fund holdings.

From a total €1.26 trillion invested across currencies and in both short-term and enhanced funds, around €300-400 billion gradually moved from standard to enhanced funds after rates went negative in the euro area (source: IMMFA).

However, investors and issuers alike eventually adapted to negative rates in the euro zone and, as euro zone banks themselves began offering negative rates on deposits, some investments returned to the money markets, largely driven by a need for diversification.9

Figure 4: Investors came back to short-term euro MMFs after initial exodus
Investors came back to short-term euro MMFs after initial exodus
Source: Source: Fitch Ratings, iMoneyNet. Total assets of euro short-term MMFs. Data as of May 29, 2020

Finding opportunities

The good news for sterling and dollar investors is that, for now, the interest rate environment is moving towards zero rather than below it, with encouraging signs rates might stay above – for now. However, the market is changing fast, and as of early July 2020, with poor economic data coming in, negative rates in the UK were looking increasingly probable, if not this year, possibly in 2021.10 It would be prudent to prepare for this possibility and to consider what may happen in such circumstances.

Investors will want to know whether their money market fund has been allocated to longer-dated instruments

As rates move lower, investors will want to know whether their money market fund has been allocated to longer-dated instruments that can lock in the higher rates still on offer two or three months ago, such as Treasury bills and high-quality banking credits for up to six months, balanced with short-dated assets to maintain liquidity levels. This will allow them to continue receiving some return on their liquidity investments for longer.

However, most of the eligible securities issued today offer zero to three basis points. As the underlying assets in their funds mature, investors are likely to see yields fall for the foreseeable future. Some may re-evaluate the proportion of their cash going into bank deposits versus that invested in a money market fund, provided their bank can continue offering a few more basis points.

Short-term funds offering “liquidity plus”-type investments can also offer some yield pickup by taking slightly higher risk in return for longer-dated opportunities and positive yields, once again balanced with ultra-short instruments to meet daily liquidity requirements. As in the euro zone, ultra-short bonds or other non-traditional assets could also support returns. Options like these could prove popular if interest rates in the UK or US were to go negative.

Change is coming

In such an environment, money market funds could change considerably. EU-domiciled Government or Treasury money market funds operating under a constant net asset value (CNAV) structure would have to convert to either LVNAV or VNAV. US-domiciled US Government and Treasury only money market funds, along with retail prime funds, must transact under a CNAV structure. If rates were to go negative, it is likely that US money market funds would reduce or waive fees, and/or suspend new subscriptions in order to keep a positive yield on the funds. If further action were needed, regulatory and operational changes would be required to allow the industry to adjust to negative yields, similar to the changes that took place in the European money market industry after rates went negative in 2014.

Over the short term, VNAV and LVNAV money market funds – government or otherwise – would most likely discount the management fees to ensure a positive or flat yield, and US funds could also suspend new subscriptions, as with CNAV funds. For funds domiciled in the EU, however, reducing fees is only possible as long as the negative yield on the fund is less than the management fees chargeable, as sponsors are not allowed to support money market funds directly under EU regulation. 

The second option would be to move existing investors into accumulating share classes, meaning the accrual/dividend would be capitalised each day. The share price would therefore rise in a positive rate environment and fall in a negative rate environment, eroding capital as seen in the euro area with VNAV funds.

What will not change is companies’ need for diversification

However, what will not change is companies’ need for diversification. Banking deposits may remain at zero for as long as they can, but a negative rate environment would make it difficult for banks to maintain this. Furthermore, investors will want to mitigate their counterparty risk exposure. Given that diversification is one of the key objectives money market funds were designed to meet, investors may remain invested in them – or return to them after some time, as happened in the euro zone.

Low to negative interest rates mean cash investors are now in a world where every basis point counts, but positive returns should not be claimed at the expense of capital preservation. Proactive management, visibility and good reporting, and diversification across the different levels of risk and maturities available are the best tools investors can use to navigate these challenging times.

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