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Viewpoints
Click here to read executive vice president and portfolio manager Jerome Schneider's bio.
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As cash and short duration investors headed back to work in the New Year, the commute was looking hairy. In the past two years, money market yields dropped to all-time lows even as price volatility for short duration instruments soared. New obstacles lie just ahead.
Along with the risk of the unexpected, these investors face four distinct challenges in the first half of the year. We refer to them collectively as LIRR. No, New Yorkers, it's not the Long Island Rail Road we're talking about "“ that's a different kind of commuting challenge altogether. LIRR stands for 1) Legislation, 2) Issuance, 3) Rates and 4) Regulation.
Just as picking the right mode of transportation can mean the difference between getting to the office on time or missing the morning meeting, investors need to select the right investment vehicle for this trip. A flexible, yet customized strategy may be the smoothest ride toward preserving capital while also maintaining liquidity and earning a competitive return.
Knowing the ins and outs of LIRR will also be critical.
Legislation. As currently drafted, the proposed Financial Responsibility Tax would charge a 15-basis-point fee on bank and broker liabilities (ex-deposits) and would offer incentives for banks to reduce capital to lower margin businesses, including money markets and liquid products desks. This could potentially destabilize liquidity in the short end by reducing the number of market makers and the supply of cash securities. While the intent of such a "tax" might be benevolent "“ helping taxpayers recoup the money they paid into the government's crisis bailout programs "“ the subsequent responses to these reforms in the banking system could produce unintended consequences, including lower yields and a reduced supply of investment options.
Issuance. Much of the cash inflow to money markets in late 2008 and early 2009 is beginning to ebb. Money market yields are so low "“ basically zero "“ that investors are considering the resumption of their risk-taking habits. Money market assets dropped about 20% in 2009, but the velocity of these withdrawals is slower than the new issuance coming to the money market space.
Banks built up a lot of cash on their balance sheets (see Chart 1), so there is less need for them to issue commercial paper (CP) or certificates of deposit (CDs) to raise cash. Similarly, the U.S. Treasury extended the maturity profile of its debt, systematically reducing the supply of T-bills. And Agencies that typically were active in money market space via discount note issuance (see Chart 2) have reduced their issuance by more than $110 billion in the past quarter alone. The upshot is that more cash is chasing fewer eligible assets, resulting in lower yields.
Rates. While the debate on when the Fed will tighten likely will continue for much of this year, we believe that the more immediate question for short-end participants is the impact of the cessation of the Fed's quantitative easing at the end of March, to be followed by steps to soak up excess reserves. If the Fed utilizes the proposed tools of reverse repurchase operations, which entails temporarily lending securities to willing market participants in exchange for cash proceeds (known as reverse repurchase agreements), and term deposit facilities to drain excess reserves, PIMCO believes the resulting effect would be to push the effective fed funds rates higher from current levels. This would drive the overnight funds rate closer to the top end (0.25%) of their current fed funds target range, and possibly slightly beyond. Likewise, if the Fed were to conduct reverse repurchase agreements directly with the government-sponsored enterprises (GSEs), they will have less excess cash to sell into the fed funds market, producing a similar upward pressure on short-term rates.
While our view is that the Fed will remain on hold for the majority of 2010 and possibly longer, the effective rate that a short-end investor could earn should moderately increase as these policy adjustments come to fruition. Nevertheless, the yield increase will likely be minor, so investors should continue their paramount focus on determining their "pure" liquidity needs. By tiering out their liquidity needs over time, investors can step beyond the money market space with a portion of their cash to increase their overall portfolio yield.
Regulation. The SEC recently released changes in 2a-7 money market fund regulations. The goal of these new rules is to provide more liquidity, increased credit quality, shortened maturity limits and trimmed-back risk in money market funds. These rules will be implemented in 2010 and are based on recommendations made last year by the Investment Company Institute and, separately, the President's Working Group on Financial Markets. The expected impact is that the rule changes should continue to keep money market rates low.
Other potential regulatory reforms range from special assessments for FDIC participants, to alterations in accounting treatments, to congressional legislation on banking reform. These changes could also result in lower money market yields.
While the structure of the market has indeed changed from its heights in 2007, we believe the situation is shifting again. This shift favors a limited risk appetite and use of tried-and-true structures that withstood the events of the fall of 2008. We believe that we will never see the so-called shadow banking system (loosely defined as a variety of non-bank financial institutions that operated legally but almost completely outside banking regulation, and contributed to the crisis by offering creative financing to businesses that in many cases were not sustainable) in full force again due to new regulations, but it is possible that elements might re-emerge. The new structures could include money market securitization structures, asset-backed commercial paper and the evolution of short-dated money market products with additional credit enhancement. We hope that these new structures will be vigilantly regulated.
Safe Travels All of these changes and potential changes should continue to conspire to keep money market rates low during 2010.
Some investors are moving out the risk spectrum slightly beyond money markets into short duration cash strategies. They are earning more attractive yields than a typical money market strategy would offer while still preserving liquidity. The path ahead for these investors may include a combination of money market and short duration strategies, depending on when and how much liquidity they need.
We urge investors to remain nimble to travel safely this year. That means being conscious about the risks "“ the LIRR as well as the real possibility of the unforeseen "“ and having a true understanding of the cash strategies they've chosen to ride.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Money Market securities are not insured or guaranteed by the FDIC or any other government agency and although they seek to preserve the value of your investment at $1.00 per share, it is possible to lose money. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO
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