How the Fed Confronts Liquidity
Concern about a lack of liquidity in money markets has created significant volatility. However, new developments have emerged for the money market industry that are designed to keep the short-term markets functioning and restore calm for investors.
The global uncertainty surrounding the coronavirus pandemic has created stress for short term markets. Credit spreads are elevated due to the lack of liquidity in money market instruments. These include commercial paper, or notes issued by corporations, and certificates of deposits, which are issued by banks to corporations and individuals.
Dealer liquidity has dramatically weakened because of balance sheet constraints approaching the March quarter-end, which is a major regulatory reporting date. Credit quality for money market funds continues to be high but, there is a significant price mismatch between buyers and sellers. This is because of a lack of demand for those securities from liquidity investors. While the repricing of short-term credit offers attractive opportunities, prime money market funds have adopted a defensive posture that focuses on maintaining stronger liquidity to accommodate any redemptions.
Fed Action Brings Liquidity
In the U.S., extraordinary intervention from the Federal Reserve ranges from dramatic interest rate cuts to injecting massive liquidity to support the short-term markets. The Fed’s “do whatever it takes” approach also recognized an urgent need to help unfreeze the money markets. As a result, the Fed temporarily reestablished three different liquidity facilities that were used during the 2008 financial crisis.
One facility targeted commercial paper issuers and another provided cheap credit to primary dealers to help facilitate a more liquid market. The third is specifically designed to provide liquidity for money market mutual funds and has made significant progress since its announcement last week. Encouragingly, the scope of eligible security types that can be pledged to the money market facility continues to expand, making many parts of the short-term markets liquid again.
In times of uncertainty and volatility, investors will undoubtedly shift into a flight-to-quality mindset and seek safety at any cost in Treasurys. As the Fed cut its policy rate 150 basis points during the month, Treasury bills are now trading with negative interest rates in maturities out to five months. That will eventually put pressure on government money market funds to find suitable investment opportunities.
New developments remain fluid. But as the pandemic disrupts the financial markets, at least some calm has been restored in the money markets. Investors should feel more confident that principal preservation and liquidity remain unwavering priorities in the money market industry.
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