Short-term investors continue to contend with a bevy of challenging headlines. While many investors, as well as regulators and policymakers, have griped about the market, actions have been few. In fact, many participants are being ambivalent, as if they were playing the match for a tie.
Nevertheless, this is no ordinary sporting event. Rather, this is the delicate balance between liquidity management, yield enhancement and risk taking, and in this uncertain environment, sometimes changing one’s offensive scheme can be the best defense.
Next year a significant event is coming that could shake things up: The Federal Deposit Insurance Corporation’s unlimited insurance coverage on demand deposits is set to expire. While by itself the event might not be a game changer, it adds to the uncertainty that looms over short-term liquidity strategies as global interest rates continue to be squeezed.
Recently, the European Central Bank (ECB) cut its deposit rate on excess reserves to 0%. The ensuing onslaught of effects is still being felt. Symptoms include euro money-market funds halting inflows and in some cases liquidating completely, repurchase agreements and T-bills trading at negative yields, and European banks turning away client interest in CDs at any level as their liquidity positions remain ample.
For European cash investors, the prospect of negative yields, or effectively, paying for the safekeeping of your monies, is a very real consequence of the ECB’s decision. In fact, several European money funds are contemplating methods by which investors will actually pay for this “defense” within current fixed NAV funds either through a fee or through the return of shares.
U.S. investors continue to have the relative luxury of a fed funds target and effective rate that remains positive. However, the market and several Federal Reserve governors have romanticized the notion that the economy would benefit from a cut in interest on excess reserves (IOER) or other monetary policies that could send front-end rates closer to 0%, if not negative.
We believe that an instant replay of the ECB's action by the Fed, namely a cut on IOER to 0%, is a remote possibility at this time. However, possibilities such as this must be considered by any prudent investor at this point in the game. Now is the time to assess viable alternatives to traditional methods in liquidity management that can offer positive real-returns to first movers ahead of this changing dynamic. We believe that actively managed short-term strategies that dynamically adjust to market conditions are viable solutions, with more attractive risk and return characteristics than money markets.
With such a temporal deadline at hand as the FDIC’s last day of unlimited insurance (31 December 2012) and so much of the game already played, it seems that the outcome of the contest will be determined by a sudden-death overtime, when all participants are forced to use the best plays they’ve practiced all season and face the moment of truth.
What’s next after unlimited FDIC insurance?
While there is a possibility that the deadline will be extended for unlimited insurance on noninterest-bearing transaction accounts, we believe that given the Congressional approval required, such a compromise is unlikely before year-end (though depositors will still be insured up to $250,000). As a result, more than $1.4 trillion in bank deposits that fall under the safekeeping of this insurance will become uninsured obligations of the bank in which such deposits reside (total deposits as of 30 June 2012, per FDIC).
Come January, what was once a virtually “risk-free” asset for investors will instantaneously become risky. Decision-makers will need to once again weigh the different alternatives, including remaining in a bank deposit, but with credit risk, or moving to other alternatives including 2a-7 money funds or more dynamic short-term strategies.
This decision is complicated by the potential for regulation of money markets. Recently the Securities and Exchange Commission (SEC) was forced to call a timeout with regards to efforts to reform regulated 2a-7 money-market funds. While the Commission’s vote to implement such well-documented reforms has been postponed indefinitely, the prospect of additional regulation remains. Given the ongoing concerns over money-fund structure voiced by the Federal Reserve and the U.S. Treasury, systemic changes to regulated money funds will likely be re-addressed in 2013, perhaps as part of initiatives undertaken by the Financial Stability Oversight Committee (FSOC). As a result, both regulators and investors must be poised to play in a changing investment environment for much longer than originally anticipated. Overtime – in 2013 or beyond – is becoming a more likely scenario for such changes to be implemented.
December 31 could likely be a significant pivot point and potential time for turbulence in the short-term markets. Not only are there the typical stresses associated with year-end investing with which to contend, but the declining supply of investable money-market-eligible investments driven by the scheduled maturity of the FDIC Temporary Liquidity Guarantee Program ($28 billion) as well as declining Agency issuance are additional sources of cross-currents. The result could make near-term liquidity even more expensive than it already is.
With taxable 2a-7 money-funds totaling about $2.3 trillion, these funds could be overwhelmed by the approximately $1.4 trillion in previously FDIC-insured deposits looking for a new home. Upon the expiry of the FDIC insurance this December, PIMCO believes that the majority of the $550 billion incremental increase in insured deposits seen since 2010 will leave this safe harbor. At such time, liquidity investors will be forced to allocate between taking the additional credit risk of remaining as an uninsured depositor, accept the cost of near 0% yields offered by the pure liquidity and assured principal protection of U.S. T-bills, or venture into more attractive risk/reward positive-yielding alternatives further out in the short-term space. Given the prospective size of more than $500 billion in potential inflows into short-term strategies, those first-movers willing to move quickly and look beyond the traditional playbook of money-market funds will likely gain the advantage.
With the confluence of potential events coming to a crescendo over the next few months, we believe that there is a definitive advantage to those investors who act promptly and decisively to address these modifications to the rules of the game. We consider a two-tier approach which combines determining immediate cash liquidity needs and investing those funds in readily redeemable assets with liquidity and quality such as T-bills or repurchase agreements. The remaining funds destined for intermediate uses can be invested in assets that capture liquidity premiums that avoid the narrow corral of money-market eligible assets.
In simple terms, this is where allocations to short-term strategies can be very compelling, as they dynamically adjust to the changing conditions – market or regulatory – within the broader market. Most importantly, they are able to manage liquidity by defining it within a broader opportunity set compared to the structural limitations of a regulated money-market fund. This in itself is a defensive scheme which must be highlighted and not overlooked.
On the offensive side, we believe short-term strategies will move the ball up the field more effectively than other options. First, they will likely benefit from the tailwind of additional interest by investors looking for viable alternatives with proven, experienced managers, and that will likely be reflected in the capital appreciation of the underlying assets as supply becomes constrained over time. There is little doubt that the upcoming removal of unlimited FDIC deposit insurance combined with continuing discussions on regulatory reform have prompted investors to consider other alternatives.
Second, in this era of confiscation, investors need to think not only about preserving capital simply in nominal terms but also in real, or inflation-adjusted, terms. While the average money-market fund might offer a minimal “safe” return on one’s investment, in inflation-adjusted terms that is likely negative. Short-term strategies may effectively help to preserve one’s capital in real terms, for an incremental increase in risk. With a dynamic game plan incorporating these strategies, the spoils of proper short-term cash management may be achieved.