Talking Heads – Money market funds have further to go

This is an audio transcript of the Talking Heads podcast episode: Money market funds have further to go.

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads Podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing money market funds. I’m Daniel Morris, Chief Market Strategist, and I’m joined by Thibault Malin, Investment Specialist. Welcome, Thibault, and thanks for joining me.

Thibault Malin: Hello, Daniel. Very happy to be here.

DM: We had a conversation several months ago and since then we’ve probably both been surprised by how expectations for central bank policy have changed, even if probably the policies themselves haven’t changed all that much. Expectations have moved: if we go back to the fourth quarter of last year, the data seemed to indicate that we didn’t need to worry anymore about a recession. And we all bought into the idea of a soft landing, meaning we saw inflation coming down quickly and then quite quickly deep cuts in policy rates, both from the US Federal Reserve and the ECB. Now, recently, the data has gone in the other direction. We’ve had higher than expected inflation. Now there’s discussion about whether that soft landing is going to happen or maybe it’s just delayed and even about the possibility that inflation could reaccelerate. Let’s focus on that change in expectations for policy rates. At the beginning of this year, the markets priced in six or nearly seven cuts from the Fed, but now we’re looking for around three cuts. Have we seen a similar movement in expectations for the eurozone?

TM: Yes, absolutely. There has been a clear change of paradigm here – at the beginning of the year, the market expected from five to six rate cuts of each 25 basis points. Now, the market three to four rate cuts, meaning that rates should be close to or above 3% by the end of the year. So, this has been our central scenario after we reached the terminal rate [of the hiking cycle] of 4% in September last year. With the latest economic data and publications by members of the ECB’s Monetary Policy Committee, we believe that it is reasonable to expect three rate cuts over the year, starting most probably in June. This is almost fully priced by the market. When we look at future curves for the short euro rates, we expect rates to be slightly higher for slightly longer than what the market currently anticipates.

In a rate hike environment, we have maintained a low duration and this approach should continue to make full sense. Why? Firstly, we believe in higher rates for longer, but also because of the inverted yield curve. Currently, it pays much more to invest at the very short end than at the long end. But buying fixed rate paper contributes less to performance than a variable rate approach when you buy a security directly pegged on the euro short-term rate. Let me give you an example. If you buy a one-year fixed rate financial security of high credit quality, which you are likely to own in a money market fund, the yield would be close to 4.20%. So clearly there is a real difference.

There is a second reason why we continue our variable rate approach: an uncertain rate environment leads to volatility in the portfolio’s net asset value because of the mark-to-market valuation of the security held. When you hold a variable rate instrument, it hedges you against the volatility of rate expectations in the market. So clearly, there is a double advantage for a money market fund in a variable rate environment. And this is reinforced by our conviction that we will have higher rates for slightly longer. These elements fully justify sticking to a variable rate approach in a money market fund. For that reason, the performance of money market funds should remain interesting until the ECB eventually decides to cut rates.

DM: We’ve been talking about the big trends that we’ve seen in terms of interest rate expectations, evolution of inflation and so on. Maybe we can talk now about the nitty gritty of how you need to manage money market funds and how really the ECB manages its own monetary policy. If I understand correctly, the ECB announced some changes to how they’re implementing monetary policy decisions. Can you talk about what those changes were and whether you expect any impact on the money market industry?

TM: That change of the monetary policy framework happens every two or three years. The ECB seeks to adapt the way it provides liquidity to the market, depending on the current economic cycle and the macroeconomic environment to make it the most relevant possible. So, it will continue to provide liquidity to the markets through the banks involving a large mix of instruments. For issuers in the eurozone, it has announced a reduction of the spread between the marginal lending facility at which banks can finance themselves versus collateral and the deposit facility rate at which banks can deposit their cash at the central bank with a remuneration. This spread between the lending and the deposit rate will be reduced from 50 basis points to 15 basis points. So clearly that’s a great reduction of how much it will cost banks to refinance themselves if they need liquidity.

It is important to keep in mind that today banks continue to benefit from a high liquidity surplus – it is  close to EUR 300 to 500 billion, leaving the most solid banks of the eurozone and even the average players comfortable in term of all the liquidity ratios that they have to maintain under the Basel III requirements despite the discontinuity of the ECB’s asset purchase programmes and the last tranche of the Tier 2 or 3 targeted long-term refinancing operations [maturing]. The last remaining maturities will be repaid this year, reducing the excess liquidity progressively. We do not expect any significant impacts from this new framework to be implemented in September 2024, at least not in the coming quarters, because of this comfortable liquidity surplus.

DM: You mentioned that policy rates will be slightly higher for longer. Nonetheless, we all anticipate by the end of the year that rates are going to be lower than they are today. It is a widely held belief that at some point we should see at least some of the massive amounts of money that have gone into money market funds since the pandemic start being reallocated to equities, fixed income or who knows what. The question today is now: Are you starting to see any redemptions?

TM: There is a particular seasonality of the dividend payments by corporates who constitute a large part of the money market funds investors. For that reason, over the coming quarter, we might see some redemptions. Corporate dividends are particularly large this year, at least in the eurozone. But as long as medium and long-term rates remain lower than the short-term rates, we don’t believe that we will see significant redemptions in money market funds because the shorter the investment, the higher the yield. Before switching to other asset classes, we will need to wait for the rate cuts to materialise and to result in steepening of the rate curve. At this stage, we have a stabilisation of money market fund assets. A large part of money market fund liabilities come from corporate clients with cash. We don’t believe any redemptions will be huge. In any case, rates are expected to remain high for the next few years. In that environment, money market funds will remain a preferred allocation for many investors who experienced negative rates over close to eight years until 2022.

DM: Thibault, thank you very much for joining me.

TM: Thank you, Daniel.