Fed Proves Irrelevant in $2.6 Trillion Slice of U.S. Debt Market

  • Money-market rules may push $650 billion into safest assets
  • Treasury's plans to increase bill issuance won't meet demand

Will Fed Raise Rates in Dec. and Then Again in March?

The blowout U.S. jobs report for October means the Federal Reserve may be weeks away from raising interest rates. For U.S. savers earning next to nothing on $2.6 trillion of money-market mutual funds, the move will barely register.

The reason is that there’s an unprecedented shortfall in the safest assets, especially Treasury bills -- a mainstay of those funds and traditionally the government obligations that are most sensitive to changes in Fed policy. The shortage means some key money-market rates will probably remain near historic lows even if the central bank increases its benchmark from near zero next month.

As a share of U.S. government debt, the amount of bills is the lowest since at least 1996, at about 10 percent, and the Treasury is just beginning to ramp up issuance of the securities after slashing it amid the debt-ceiling impasse. Meanwhile, regulators’ efforts to curb risk after the financial crisis are stoking increased demand: Money-market industry rules set to take effect in October 2016 may lead investors and fund companies to shift as much as $650 billion into short-maturity government obligations, according to JPMorgan Chase & Co.

“The demand for high-quality short-term government debt securities is insatiable and there is just not enough supply,” said Jerome Schneider, head of short-term strategies at Newport Beach, California-based Pacific Investment Management Co., which oversees $1.47 trillion. “Even given the increased bill sales coming as the debt-limit issue has passed, it won’t keep up with rising demand from regulatory forces. This will keep rates low.”

While the U.S. government stands to benefit as the imbalance holds down borrowing costs, it’s proving the bane of savers. Average yields for the biggest money-market funds, which buy a sizable chunk of the $1.3 trillion Treasury bills market, haven’t topped 0.1 percent since 2010, according to Crane Data LLC. In 2007, they were above 5 percent before the Fed started slashing rates to support the economy.

With returns this low, investors have less incentive to sock away cash. The Standard & Poor’s 500 index has earned 3.8 percent this year, including dividends, according to data compiled by Bloomberg.

The one-month bill yield was at 0.04 percent as of 12:35 p.m. New York time, after touching as low as negative 0.05 percent last month. The Fed effective rate, the average rate on overnight loans between banks, is 0.12 percent.

The U.S. sold $30 billion of three-month bills at a rate of 0.135 percent and $28 billion of six-month bills at 0.34 percent. The bid-to-cover ratio, a gauge of demand, for the three-month bill sale was 3.31 percent, the least since October 2013.

Mary Lee Wegner, a 54-year-old Los Angeles lawyer, is among investors eschewing money funds for higher-yielding choices as her financial adviser, Ross Gerber of Gerber Kawasaki, tells her rates will remain low even after the Fed begins tightening.

“The Fed has forced me to become a more willing investor, because if I decided to keep a large portion of my money in savings with the level of inflation and zero interest rates, I’m losing money,” Wegner said. “I don’t have much of a choice but to be less risk averse.”

Next Challenge

The new rules threaten to roil the industry as much as near-zero interest rates.

Regulators are trying to make money funds more stable after the 2008 collapse of the Reserve Primary Fund, as bets it made on Lehman Brothers Holdings Inc. debt soured. The decline in its share price below $1 triggered a run on money funds that contributed to freeze credit markets.

The new Securities and Exchange Commission measures, which include redemption fees in times of market stress, apply to so-called prime funds, which can also buy corporate debt such as commercial paper. Under the new regulations, institutional prime funds must have a floating share price.

BlackRock Inc., Federated Investors Inc. and Fidelity Investments are among asset managers changing money-fund offerings in response to the shifting rules. They’re converting prime funds to choices focused on government securities, including bills and agency offerings. Those funds will retain the stable $1 share value that’s been a bedrock assumption of money markets.

Bill Imbalance

Adding to the supply-demand imbalance in bills, higher capital requirements have led some banks to place fees on deposits, pushing savers into short-term government securities.

“There has been tens of billions that has flowed into the government money-market sector, but it’s about to turn into hundreds of billions,” said Peter Crane, president of Crane Data, a Westborough, Massachusetts-based firm that tracks the industry. That pressure will “keep government and Treasury rates nailed to zero.”

The upshot is that the history of bill rates during past Fed tightening cycles won’t serve as a guide this time around. The last time the Fed was raising rates, it pushed its benchmark from 1 percent in June 2004 to 5.25 percent two years later. In that period, one-month bill rates rose from about 1 percent to around 4.5 percent.

Fed Approach

Bill rates may climb more quickly if the Fed expands its reverse repo program, or RRP, which it will use to suck liquidity from the financial system and guide rates higher. The RRP rate, now fixed at 0.05 percent, will be the floor for the Fed’s target band, while the interest rate on excess reserves -- now 0.25 percent -- will be the top. The Fed allows a maximum of $300 billion in daily use of its RRP. In these agreements, the Fed temporarily borrows cash from counterparties using securities as collateral.

“How big the RRP program gets will have a big impact on where bill rates go in the Fed liftoff,” said Alex Roever, head of U.S. interest-rate strategy at JPMorgan. “That will matter to the bill market because the Fed RRP’s are going to be a substitute, and likely a higher-yielding one, for short-term Treasury bills.”

Even though the Treasury said last week that it plans to ramp up bill sales, most investors say it still won’t be enough.

“Bill rates are going to be low relative to other rates due to the supply-demand imbalances,” said Steven Meier, the Boston-based head of cash, currency and fixed-income at the money-management unit of State Street Corp., which oversees $2.4 trillion. “And this gets worse in 2016 and it gets worse quickly. Bill rates have been sticky on the downside and slow to move.”

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