Short-term fixed income assets sold off in March as investors sought to de-risk and indiscriminately raise liquidity in response to fallout from the global health crisis. Jerome Schneider, PIMCO’s head of short-term portfolio management, discusses the outlook for short-term assets given recent Fed announcements of support, how a possible resurgence of COVID-19 could affect liquidity markets, and the future of Libor (the London Interbank Offered Rate) as a benchmark for trillions of dollars of financial instruments.
Q: Short-term markets got hit hard in the first quarter, along with other market segments. Could we see that again, such as if we see a resurgence of Covid-19, or have the Federal Reserve’s actions bolstered liquidity enough?
A: Concerns about risk markets at the beginning of the global economic shutdown in mid-March prompted investors to de-risk and maintain higher levels of liquidity. Unlike the global financial crisis (GFC), this recent period of stress was founded upon concerns about liquidity rather than systemic solvency, which put money-market and short-duration assets at the vortex of the volatility. For U.S. dollar investors in short-term markets, this sparked unprecedented flows into U.S. government money market funds and out of prime funds, which can take credit risk and were subsequently forced to sell assets in order to maintain their required liquidity buffers. The resulting lack of appetite for new issue credit (bank and financial) holdings and the forced selling of short-term assets, including financial commercial paper (CP) and certificates of deposit (CDs), propelled credit spreads and absolute yields to rise relative to risk-free benchmarks such as the fed funds rate, the overnight index swap rate (OIS), and the Secured Overnight Financing Rate (SOFR). Libor, the benchmark proxy for many credit-indexed instruments, also widened relative to OIS and SOFR, reflecting underlying stress in money markets. The spread of Libor versus OIS reached a peak of 138 basis points (bps) on 31 March, indicating sharply reduced risk appetite and elevated demands for liquidity.
Financial institutions’ efforts to raise funding during this period of stress were challenged. Even though banks offered CP at historically wide spreads of up to 100 bps above Libor in an attempt to lure investors, the lack of demand at any premium simply caused new issuance to plummet. Secondary market liquidity was even worse, with high quality CDs trading at distressed levels as dealers hoarded liquidity. It wasn’t until the Federal Reserve Board of New York stepped in to support money markets via the Money Market Mutual Fund Liquidity Facility (MMLF) and the Tier 1 commercial paper market via the Commercial Paper Funding Facility (CPFF)1 that credit conditions began to stabilize and then ease (see chart).
Since 23 March, the array of announced Fed-sponsored programs has helped provide stability by injecting liquidity directly into affected segments of the money markets, as well as by outlining additional support to front-end credit markets. While surprising given regulators’ reluctance to support a backstop to prime funds after the GFC, the MMLF has provided specific relief as an outlet for prime money funds to sell their credit holdings, thereby raising much-needed liquidity and easing concerns that prime fund investors might be gated (i.e., face a temporary suspension of redemption privileges) due to eroding liquidity buffers.
The Federal Reserve’s broad-based support for liquidity and credit markets via their announced loan programs has helped to quell the dire sentiments observed in March and set us on a path toward normalcy. Further, the central bank has demonstrated a profound commitment to support the economy throughout the medium-term recovery associated with the COVID-19 crisis, as Fed officials remain visibly supportive of these emergency measures. Vice Chair Richard Clarida, in a recent CNBC interview, reminded markets that the Fed will “continue to be forceful, proactive and aggressive” to combat the recessionary impulses while having the ability to “expand those lending programs as needed.” While the Fed is clearly on call to help put out any rekindled fires, savers and investors should not be complacent in this evolving economic environment. Rather, they should actively evaluate the pros and cons of risk allocations as well as costs of de-risking entirely to money funds.
Q: How is the recovery in short-term markets progressing? What is the outlook?
A: Short-term markets have begun to stabilize. Nevertheless, market liquidity remains thin and credit spreads remain elevated and sensitive to not only the trajectory of the virus’ economic impact, but to the challenges presented by everyday market function, which are a consideration for liquidity as many dealers and banks continue to operate with less-efficient work-from-home structures. Moreover, there is potential for further credit weakness spurred by deteriorating corporate earnings or possible bankruptcies of high-yield credit issuers. Furthermore, concerns over corporate credit will remain for the cyclical horizon despite prime fund outflows stabilizing. We expect the CPFF will be a cornerstone of stability for credit as it provides a funding backstop to high quality – mostly financial – credits, prompting Libor to turn a corner toward easier financial conditions. The move lower in daily Libor resets, including a 10-bp decline on 24 April, had been building for a few days. Bank issuance has expanded to meet reemerging demand from prime funds, and bank offerings have been moving sharply lower, pushing three-month Libor below 0.90% for the first time since mid-March. Market expectations indicate future spread tightening, with forward expectations for June Libor-OIS sitting at 0.32% (32 bps) versus spot at 0.76% (76 bps). In other words, the market expects the front-end credit market to converge toward pre-crisis levels over the next few weeks.
We expect Libor to continue to decline due to the Fed’s continued sponsorship of lending programs. In fact, further declines in Libor would not be surprising given the aggressive levels of recent bank CP and CD issuance. Remember, Libor is a financial credit index after all.
We believe an important takeaway is that many nonfinancial issuers in highly cyclical industries most affected by the crisis have been left with no source of short-term funding, as no backstop has emerged to facilitate access to CP markets for working capital needs at levels prior to COVID-19. This creates a segregated market between the higher-quality, mostly financial entities that can continue to seek short-term funding at consolidating spread levels supported by the MMLF and CPFF, and those mostly Tier 2 nonfinancial issuers that will continue to be forced to pay a premium to issue short-term debt and commercial paper.
Q: Does the outlook present any emerging opportunities?
A: As concerns about the trajectory of the economy continue to percolate, investors from all avenues have become increasingly defensive and continue to allocate more assets to cash strategies. A return to the zero lower bound has us thinking about emerging structural opportunities for short-term investments, as unfortunately the Fed’s monetary policy benchmark hovering at 0% does little to reward the broadening corral of investors looking for safety and income while maintaining a defensive posture. Similar to the previous episode of ZIRP (Zero Interest Rate Policy) in 2012, we believe the best solution will be active evaluation of liquidity needs and tiering your cash capital between immediate and intermediate liquidity needs. Front-end investors who remain flush with cash due to a defensive orientation may benefit from high quality, short-dated, floating-rate assets and strategies that can take advantage of this structural tailwind of elevated liquidity premiums versus the near-0% benchmark rates offered by traditional government money market funds.
We believe that an elevated differential in the Libor-OIS spread will remain for the rest of the year – perhaps 30 bps to 40 bps on average – creating relative opportunities for income and total return for fixed income investors with defensive capital allocations. Potential allocations of high quality, shorter-dated investments may continue to benefit from yields that remain firmly above 0%, especially those indexed to Libor, far into the future as the Fed and other central banks continue to provide support for markets and the broader economy.
PIMCO will actively look to build on the lessons learned in managing portfolios during the previous episode of near-zero rates in 2012–2015 and embrace this potential for structural income.
Q: Finally, what is the future of Libor?
A: This year is expected to mark the beginning of the end for Libor after trust in the traditional benchmark for short-term credit rates was shaken in 2012, when several contributing banks for the reference rate were accused of manipulating it. Since then, market participants and regulators globally have been working on alternatives. New benchmarks, including the Secured Overnight Financing Rate in the U.S., are on track for adoption commencing the end of 2021.
The Covid-19-related market turmoil in March has reminded us that Libor remains relevant and that it has some utility as a barometer of the price of liquidity vis a vis credit within the financial system. However, recent market turbulence has not only diverted resources from the scheduled transition efforts toward SOFR, but more recently the Fed’s response to assist the economy via the Main Street Lending Facility has potentially undermined its own desire to move away from Libor. As noted in a recent Fed FAQ, the Fed’s desire to incorporate SOFR as the base index for borrowings from their Main Street facility met stiff resistance from regional banks and borrowers who felt they were woefully ill-equipped to deal with calculations of SOFR, and preferred status quo reference rates, including Libor. The impact of this unexpected grassroots rebellion has been felt throughout the corridors of Wall Street and the Eccles Building in D.C.2 While the transition to SOFR as a primary index for short-term rates will likely continue, it is equally likely that the market will continue its search for a proxy benchmark for short-term credit conditions.
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