With the extraordinary recent efforts by the Bank of Japan to reflate its economy marching ahead, the number of entrants in the quantitative easing (QE) parade continues to grow. Over the past 20 months, uneven growth and unemployment trends have elicited a colorful spectrum of central bank responses − more than 275 easing measures in total − all at different times and of differing intensities. For the QE parade watchers, it’s almost as if entrants are arriving for different starting times: Just as one bank begins to march with full vigor down the route, another is looking to pack up and go home. Despite these uncoordinated central bank responses, the impact on risk assets − particularly on investors’ perception of their riskiness − has been clear: Yield spreads have tightened and term premiums have compressed.
In the U.S., improved growth and economic data earlier this year have persuaded certain investors that the Federal Reserve might begin to taper its asset purchases as early as the second half of this year. However, in our view, the “ticker tape-r” parade is further in the future. Growth patterns in the U.S. remain unconvincing to the majority of Federal Open Market Committee (FOMC) members.
Undoubtedly, these QE efforts are made to stoke the fires of growth. However, the ancillary effect of the QE parade has been excess liquidity. Indeed, for short-term investors, in particular, it is raining liquidity on the QE parade: The demand for short-term assets with little or no credit risk has increased since the financial crisis and is likely to continue rising. In recent months, it has also become clear that the supply of such perceived “safe” assets is shrinking, creating a dilemma for yield-starved cash and short-term investors.
Continuously rising demand
Since December 2008, short-end investors have felt the consequences of the Federal Reserve’s zero interest rate policy (ZIRP). Cash investments in either deposits or traditional money market funds have been earning at best a few basis points and in many cases 0%. Realizing that ZIRP is likely to continue well into late 2015, many cash investors have begun to reassess their true cash needs and tier their cash investments, investing a portion that is not needed for liquidity in short-term assets outside of traditional money market space in an attempt to earn additional return. This has caused additional demand for short maturity investments.
Long-awaited regulation of money market mutual funds may drive demand even higher. Recent discussions have suggested that SEC Chair Mary Jo White would be open to a bifurcated regulatory action, and industry participants expect that “prime” money market funds, which take additional credit risk in an effort to earn higher returns, will need to adopt a floating NAV (net asset value) structure while funds that invest only in government-issued obligations such as U.S. Treasuries may be able to maintain the traditional $1 NAV structure. That is likely to drive money market investors who need a stable NAV away from prime funds – but not to other money market funds. Instead, used to slightly higher yields, these investors will likely seek alternatives that offer more yield than the 0.02% that most government-security-only 2a-7 funds earn. Judging by recent outflows from 2a-7 regulated money market funds as detailed in Figure 1, this movement has already started.
The coming challenge: dwindling supply
However, the demand side is only half the story. The environment for short-duration and liquidity-minded investors will only grow more complex in the coming months.
During the past five years, adept short-term and low duration strategies have been able to find attractive assets that balance credit and liquidity risks at attractive yields. However, the task has become challenging amid the ongoing effects of QE and the ongoing search for yield, and now will likely become more difficult because the supply of investable assets looks set to decline further.
Issuance of short-term assets has dropped noticeably so far this year. Negative supply forecasts dominate for many types of issuers − sovereign, nonfinancial corporate and banks issuing commercial paper or covered bonds. We believe the demand for assets will only grow, especially for high-quality credits with the inherent liquidity that stems from having no links to weak sovereigns, while the supply universe will be increasingly constrained as borrowers’ need for funds declines.
Sometimes even good news turns out to be bad news on the supply front. The recent announcement by the U.S. Treasury that it would issue floating-rate notes as early as the fourth quarter of 2013 should have brought cheers from the investment community. However, it is likely that this new supply will be offset in part by a one-two punch: a reduction in T-bill supply and reduced Treasury issuance due to lower deficit spending by the U.S. government in 2014 (see Figure 2).
Even traditional repo (repurchase agreement) activity, an overnight cash investment, will likely continue to wane as banks transition toward longer-term funding to meet the requirements of Basel III and other regulatory measures.
In one of the most liquid sectors, commercial paper (CP) yields and term premiums have begun to compress once again as investors compete for a finite, and decreasing, amount of supply (see Figures 3 and 4). As the race to remain invested at any level heats up, yields within many widely held names, including bank and financial CP, will continue to decline as issuers term out their obligations with longer-dated maturities.
This yield compression in financial CP will likely have an important effect on LIBOR submission levels. Recent reforms aim to tie LIBOR levels more closely to transactions, and as a result, the declining supply / increasing demand trends will likely drive yields lower for CP offerings and put downward pressure on U.S. dollar LIBOR in the coming months. We believe this could result in three-month U.S. dollar LIBOR resetting at or below 0.24% − more than three basis points lower than current levels.
Most important, the supply-demand mismatch for CP will give many issuers the upper hand in setting funding levels and issuance spreads. This is particularly true for CP issuers who are able to term out a portion of their financing needs at increasingly attractive (low) coupons. Additionally, new issue concessions (new debt offerings have traditionally been priced at higher spreads than secondary offerings from the same issuer) are growing increasingly slim, as shown in Figure 5. We believe all investors will need to be more discerning than ever about their compensation for not only credit risk but also liquidity risk, as a result of this tightening phenomenon.
Meeting the challenge
This brings the parade back to the starting line. With these supply-demand trends forecast for the next 12 to 18 months, PIMCO believes that maintaining adequate portfolio liquidity while earning an attractive return on cash will become ever more challenging and costly amid lower yields. However, simply because many central bank target policies are currently set near 0% does not mean that investors need to be complacent and accept such returns. Instead, we suggest investors follow a new parade route: In our view, total return in short-term cash management is essential.
While yield is one means of comparing assets or strategies, we believe investors should examine investment opportunities on multiple axes. In our view, total return, which combines carry (yield) and capital appreciation, is the most effective approach when managing short-term liquidity strategies. PIMCO has developed the total return philosophy for longer duration strategies over four decades and has applied the same approach over the past decade within our own short-term strategies.
Simply put, we believe actively managed short-term strategies have the potential to outperform over the secular horizon versus yield-focused money market strategies due to their ability to dynamically assess changing credit and liquidity environments and identify opportunities proactively. Performance is something to be measured beyond book accounting yield, which is often used to compare money funds. Rather, PIMCO’s short-term strategies aim to offer total returns and performance in excess of the yield or carry metrics found in today’s money market universe. Investors need to put their spectacles firmly on, survey the landscape with both eyes wide open and actively look for strategies (whether ETFs, mutual funds with floating NAVs or separate accounts) that offer the potential for total returns in excess of the near 0% many money market strategies are offering.
PIMCO’s short-term portfolio management team has been positioning for continued supply-demand constraints. We look to sidestep underappreciated and (at times) mispriced risks by performing our own credit due diligence with our team of more than 45 credit analysts globally and by managing our short-term portfolios with a dedicated group of portfolio managers who themselves actively trade within the markets daily. With this expertise and our global resources, PIMCO aims to identify compelling assets at attractive prices.