Investment Insights
Has US financial sector reform created
excess demand for government securities?
Invesco Fixed Income, May 26, 2016
Executive summary
Justin Mandeville
Portfolio Manager
We believe increased US Treasury bill issuance plus the US Federal Reserve’s (Fed) reverse repurchase
program (RRP) will largely accommodate the anticipated increase in demand for government securities
due to money market and banking sector reform. While there are still some unknowns, namely the total
volume of assets that will ultimately shift out of prime MMFs into government MMFs, our conclusion is
based on several supportive factors that should help alleviate supply concerns. In particular, the US
Treasury and Fed have assured market participants that they are committed to ensuring that money
markets remain functioning and efficient through modifications in their issuance structure and the
implementation of monetary tools, such as the RRP.
Key takeaways
We believe several supportive factors will help ease concerns over the supply of US government
securities:
•Anticipated increase in US Treasury bill issuance
•Expected issuance of Federal Home Loan Bank (FHLB) notes
•Advent of Fed’s RRP
•Increased availability of short-term investments to foreign investors
Financial sector reform spurs asset shift
Final implementation of US money market reform is on the horizon. New regulations designed to
protect investors and strengthen the US money market industry are leading to a shift in assets from
prime money market funds (MMFs) to government MMFs — with more to come. This potential
transition has raised concerns over whether the supply of US government securities will be sufficient
to meet demand. Additionally, new banking sector regulation under Dodd-Frank legislation (financial
regulations aimed at protecting US consumers and promoting financial stability) and Basel III
guidelines (regulatory framework designed to improve the strength of the global banking sector)
could reinforce the growing demand for government securities.
Implications for the US money market
Money market fund reforms, which must be implemented by October 14, 2016, require institutional
prime and municipal MMFs to adopt a floating net asset value (FNAV), which allows the share price
of these funds to fluctuate daily with changes in the market value of the funds’ assets. Government
MMFs, on the other hand, will be permitted to maintain a constant NAV. The possibility of volatility in
the FNAV of institutional prime and municipal MMFs has already prompted many liquidity investors,
for whom principal stability is a primary concern, to transition from prime to government money
market portfolios.
This document is intended only for Professional Clients and Financial Advisers in Continental Europe, for Professional Clients
in Dubai, Guernsey, Ireland, the Isle of Man, Jersey and the UK; in Hong Kong for Professional Investors, in Japan for Qualified
Institutional Investors; in Switzerland for Qualified Investors; in Taiwan for certain specific Qualified Institutions/Sophisticated
Investors only; in Singapore for Institutional/Accredited Investors, in New Zealand for persons who are not members of the public
(as defined in the Securities Act), and in Australia, and the USA for Institutional Investors. In Canada, the document is intended
only for accredited investors as defined under National Instrument 45-106. In Chile, Panama or Peru, the document is for oneto-one institutional investors only. It is not intended for and should not be distributed to, or relied upon, by the public.
The new MMF regulations have also incentivized the MMF industry to shift many of its offerings from
prime MMFs to government MMFs. In the first phase of the transition, several financial complexes
have reclassified or converted prime MMFs to government MMFs. According to Crane Data, an
estimated USD290 billion in money market assets are in the process of being converted from prime
to government funds.1 As of April 2016, more than 85% of these assets had completed this
conversion.1 The second phase is likely to be a shift in assets by investors and intermediaries.
However, the total amount of this potential prime-to-government asset migration is still uncertain
and difficult to quantify. JP Morgan and Barclays estimate that a total of USD500-USD700 billion in
assets will likely migrate from prime MMFs into government MMFs by October 14, 2016.
Figure 1: Prime MMF assets versus government MMF assets
• Prime MMF Assets • Government MMF Assets
USD Jan-15
(trillion)
Mar-15
May-15
Jul-15
Sep-15
Nov-15
Jan-16
Mar-16
May-16
1.5
1.4
1.3
1.2
1.1
1.0
0.9
Source: Bloomberg L.P., data from Jan. 7, 2015 to May 11, 2016.
Amid this large migration, money market investors are asking whether there will be sufficient supply of
US government securities to satisfy rising demand. If the demand for US government securities
significantly outpaces available supply, price dislocations in money market instruments could result,
including potentially negative interest rates in the US Treasury and agency sectors of the money market.
Based on a number of factors outlined below, we believe the supply of US government securities will
be generally sufficient to meet rising demand in the coming months. In particular, recent comments
made by the US Treasury and the Federal Reserve Bank of New York reassured investors that they
are committed to ensuring sufficient access to government securities to meet investor demand.2
According to their recent statements, providing sufficient access will be accomplished by either
increasing the supply of US Treasuries (the Treasury has already increased its issuance of Treasury
bills in recent auctions while simultaneously reducing its issuance of longer-dated securities and
Treasury Inflation-Protected Securities (TIPS)), or through the use of tools provided by the US
Federal Reserve (Fed), such as its overnight reverse repurchase program (RRP), which is accessible
to many large MMFs.
What could impact the supply and demand for US government securities?
Below we outline some of the factors that are likely to impact the supply and demand for
government securities in the coming months.
The following factors are likely to drive up the demand for US government securities or lessen
their supply:
Money market reform
As mentioned above, US money market reform has already caused many money market providers
and investors to shift from prime MMFs to government MMFs. This trend will likely continue ahead of
the upcoming October reform deadline. For example, new rules requiring floating net asset values for
institutional prime and municipal MMFs and newly instituted liquidity fees and/or redemption gates
may cause MMF investors and providers to reassess their strategies and consider moving to
government MMFs.3
Banking sector reform
Increased capital and liquidity requirements as a result of banking sector reform are changing the
landscape for banks. New rules require large banks to hold more high-quality liquid assets (HQLA)
against certain types of deposits. HQLA include Treasury bills, meaning that banks’ Treasury bill
demand could increase under the new rules. MMFs could also experience an inflow of assets as large
US banks shed deposits that are expensive to maintain. Additionally, Dodd-Frank regulations provide
more favorable treatment of US Treasury securities used as collateral in margin posting, which could
further increase the demand for Treasury bills. Finally, there could be increased demand for
government securities among foreign banks due to the reduction in the amount of private sector repos
available to foreign banks under new US banking regulations set to be implemented by July 2016.
The following factors are likely to help ease concerns over the supply of US government
securities:
Anticipated increase in US Treasury bill supply
In the February 2016 minutes of the US Treasury Borrowing Advisory Committee (TBAC) meeting,
committee members acknowledged the increased demand for Treasury bills stemming from money
market reform and banks’ need for HQLA due to banking sector reform. The Treasury has estimated
that it can meet the projected demand for government instruments by increasing Treasury bill
issuance by USD230 billion in 2016 and an additional USD65 billion in 2017.4 The Treasury plans to
accomplish this goal by cutting USD1 billion each from longer maturity 5, 7, 10 and 30-year auctions
and USD2 billion in TIPS issuance.5 While increased demand could lower Treasury bill yields
somewhat, we believe increased issuance of Treasury bills should alleviate downward pressure on
Treasury bill yields and keep them from entering negative territory. Figure 2 below shows the US
Treasury’s supply and demand projections for government securities.
Figure 2: Estimated imbalance for short-term safe assets (USD billion)
2016
2017
Government-only money fund balances
300
100
Bank deposit outflows
150
0
50
50
500
150
–90
–90
Demand for short-term safe assets
Other demand (HQLA, margin)
Total
Supply of safe short-term assets
Private sector repo
FHLB issuance
75
25
RRP usage
285
150
Total
270
85
–230
–65
Projected supply imbalance
Source: The Treasury Borrowing Advisory Committee presentation, Feb. 2, 2016.
Expected issuance of Federal Home Loan Bank (FHLB) notes
Increased issuance of agency discount notes by the FHLB in recent years has largely replaced the
reduction in issuance by US government sponsored enterprises and mortgage securitizers, Fannie
Mae and Freddie Mac. Total issuance of these US government agency notes has remained relatively
stable, as seen in Figure 3 below.
Figure 3: US agency discount notes outstanding
• Federal Home Loan Bank (FHLB) • Fannie Mae and Freddie Mac
USD
(billion)
Jan-15
Apr-15
Jul-15
Oct-15
Jan-16
Apr-16
800
700
600
500
400
300
200
100
Source: Barclays, January 31, 2013 to April 30, 2016.
Advent of Fed’s RRP
The Fed’s RRP is an important source of “supply” for liquidity investors seeking short-term
investments. While this program was previously limited to a maximum daily capacity of USD300
billion, the RRP is now unlimited to eligible participants (large MMFs). The removal of this cap in
December 2015 provided relief to several eligible counterparties (20 banks, 13 government
sponsored entities and 28 investment management firms). With the removal of the cap, the
country’s largest MMFs (those with assets under management of more than USD5 billion) and other
eligible institutions now have the option to invest at the RRP rate (currently 0.25%), creating a
potential floor under money market interest rates.6
In a recent speech, Simon Potter, Executive Vice President of the Markets Group of the Federal
Reserve Bank of New York, highlighted that, even after the completion of the majority of planned
conversions from prime MMFs to government MMFs, the Fed has not seen an uptick in the usage of
the RRP facility.2 We think this indicates a well-functioning market where the majority of investors are
not forced to purchase US Treasury and agency securities at yields below the offered rate of the RRP.
Increased availability of short-term investments to foreign investors
The Fed provides an overnight investment facility to foreign central banks, foreign governments and
international official institutions known as the foreign repurchase pool, where cash balances are
invested in overnight reverse repurchase agreements with the Fed. The Fed has reduced constraints
on the size of these investments, leading to increased use of this facility from around USD100 billion
in the middle of 2014 to approximately USD247 billion as of February 2016.7 The increased
availability of this important short-term investment to foreign investors should help reduce demand
pressure on US Treasuries.
Conclusion
We believe increased US Treasury bill issuance plus the Fed’s RRP will largely accommodate increased
demand for government securities as a result of money market and banking sector reform. While the
total volume of assets that will ultimately shift out of prime MMFs into government MMFs is difficult to
quantify, our conclusion is based on several supportive factors that should help alleviate supply
concerns. In particular, the US Treasury and Fed have assured market participants that they are
committed to ensuring that money markets remain functioning and efficient through modifications in
their issuance structure and the implementation of monetary tools, such as the RRP.
1 Crane Data, May 3, 2016.
2 Source: US Treasury Borrowing Advisory Committee minutes, Feb. 2, 2016. Remarks by Mr. Simon M. Potter, Executive Vice President of the Markets Group of
the Federal Reserve Bank of New York, at the 70th Anniversary Celebration of the School of International and Public Affairs at Columbia University, New York
City, Feb. 22, 2016.
3 Liquidity fee — If a fund’s weekly liquid assets fall below 30% of the fund’s assets, redemptions may be subject to a 2% fee upon determination of the fund’s
board. If the fund’s weekly liquid assets fall below 10%, redemptions will be subject to a 1% fee unless otherwise determined by the fund’s board. Redemption
Gate — If a fund’s weekly liquid assets fall below 30% of the fund’s assets, fund redemptions may be suspended for up to 10 days in a 90-day period upon
determination by the fund’s board.
4 The Treasury Borrowing Advisory Committee minutes, Feb. 3, 2016.
5 The Treasury Borrowing Advisory Committee presentation, Feb. 2, 2016.
6 Federal Reserve Bank of New York, as of May 17, 2016.
7 Credit Suisse, as of Feb. 7, 2016.
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This document is intended only for Professional Clients and Financial Advisers in Continental Europe, for Professional Clients in Dubai, Guernsey, Ireland, the Isle of
Man, Jersey and the UK; in Hong Kong for Professional Investors, in Japan for Qualified Institutional Investors; in Switzerland for Qualified Investors; in Taiwan for
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