GLOBAL CASH OUTLOOK 2018 - Cash Investment Prospects in a Shifting Rate Environment - State Street Global Advisors
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GLOBAL CASH OUTLOOK 2018 Cash Investment Prospects in a Shifting Rate Environment
Global Cash Outlook 2018
3 Looking Forward in 2018
4 Macro Backdrop
Economic Environment in 2018
Central Banks — Ending the Era of Cheap Money?
10 Regulatory Update
EU Money Market Reform in 2018
How Investors May React to Changes
14 Credit Market Outlook
The Resilience of the Credit Cycle
18 Capital Markets Outlook
An Evolving Marketplace for Cash Investors
2Looking Forward in 2018
As 2018 gets under way, cash investors are likely to
see a continuation of the trends that developed
through the past year. With most parts of the
global economy on a growth trajectory, an
overarching theme of tightening monetary policy
may ripple through financial markets, even as
central banks around the world are at different
points in the interest rate cycle.
While some are continuing to operate extremely accommodative policies,
other central banks are likely considering interest rate increases in the year
ahead. For cash investors that have been subject to record low, and even
negative, returns in recent years, any upward pressure on short-term rates
would be viewed as a welcome development.
Once again, it is clear that the US Federal Reserve (Fed) is going to be the
pace-setter with three rate hikes penciled in for 2018. Brexit remains the
dominant issue for Britain to deal with in 2018, and the Bank of England
(BOE) will have to balance relatively high inflation with the impact that
increased interest rates can have on a fragile economy. Elsewhere in Europe,
the European Central Bank (ECB) will likely leave policy rates unchanged for
another year. The ECB will not exactly be a bystander, but given the excess
liquidity still washing around the financial system the planned reduction in
the bank’s quantitative easing (QE) program in 2018 will likely have no impact
on the negative money market rates prevalent in the eurozone.
Things to watch for in the US will include the Fed’s progress towards
unwinding its US$4.5 trillion balance sheet, the likely increase in borrowing
and the implications these measures will have on Treasury supply.
In Europe, we believe the ECB’s asset purchase program will continue to
distort the risk premium in both the sovereign and credit markets, likely
ensuring yields remain deep in negative territory. Cash market participants
in Europe will be contemplating European money market reform, although
most of that reform would largely affect US assets. Cash investors will likely
continue to experience frustration as they seek to maintain principal in a
negative yield environment.
Please reach out to your SSGA representative if you need any assistance with
your cash requirements over the coming year.
Pia McCusker
Global Head of Cash Management State Street Global Advisors
State Street Global Advisors 3Global Cash Outlook 2018
THE MACRO
BACKDROP
More than ten years after the first tremors of what would become the global financial
crisis, SSGA expects global growth to return to its trend rate of 3.7% as GDP
improvements spread around the world. The International Monetary Fund (IMF)
expects only six of the 192 economies it covers to fail to grow in 2018. The key
question now is whether this pick-up is more than just a cyclical upswing.
1 Global economic
growth to quicken 2 Three interest
rate hikes likely in 3 ECB likely on hold
for another year
in 2018 United States
4This year should build on the improvements seen in 2017 Emerging markets (EMs) joined the upturn in 2017 as
in both developing and advanced economies. How the Brazil and Russia exited recession. This year, we think
US economy develops in 2018 largely depends on how EM growth will likely quicken to a five-year high of
corporations strategise around tax cuts that have now 4.9%, underpinned by four fundamental factors: a
been legislated for. Still, we expect a slight acceleration pick-up in global trade; higher commodity prices; a
of growth from 2017’s projected 2.2% level helped in part weaker US dollar; and monetary policy shifting to a
by ongoing hurricane-related rebuilding. pro-growth agenda.
One of the biggest positive growth surprises of 2017 was
Europe, where the quality of growth has been good. For
2018, we expect a slight moderation of growth to 1.9%,
reflecting the recovery of oil prices, appreciation of the
euro, and the impending tapering of the ECB’s asset
purchase program.
First Acceleration in Global Growth Since 2014, Best Results Since 2011
%
7
6
5
4
3
2
1
0
-1
70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15 18
Year
World Gross Domestic Product (GDP), % chg y/y
SSGA Economics Forecast
Long-term Average Growth (3.7%)
Source: IMF, SSGA Economics as of October 17, 2017. Past performance is not a guarantee of future results. Forecasts (the lighter
shaded bars to the far right) are based upon estimates and reflect subjective judgments, assumptions, and analyses made by SSGA.
There can be no assurance that developments will transpire as forecasted and that the estimates are accurate.
State Street Global Advisors 5Global Cash Outlook 2018
CENTRAL BANK
OUTLOOK
The guidance of central bankers has been the touchstone of many investors
over the past decade as they typically signaled their next policy action to the
market. While there is validity to claims that this type of spoon-feeding is
unnecessary, the tying of policy decisions to particular economic indicators
may help avoid scenarios where the market is blind-sided by unanticipated
actions of policy makers. Nonetheless, with the global economy developing
solid growth characteristics, the pressure to reverse ultra-loose monetary
policy is on the rise.
Change at the Fed
With a change of leadership at the Fed, the US central bank is firmly in the
spotlight as 2018 begins. President Trump announced in November that
Jerome Powell would succeed Janet Yellen as Chair of the Federal Reserve in
February 2018. As an existing member of the board of governors, Powell
provides a high degree of market-reassuring continuity. Policies that have
fostered a solid economic recovery and a record-high stock market are likely
to continue, but now under a Trump appointee rather than a holdover from
the Obama administration.
As with any new Fed leader, the markets will closely follow Powell’s initial
words and actions for any subtleties that might signal policy change. The good
news is that he assumes the helm at an important inflection point in the global
economic recovery, as growth continues to spread and strengthen and
inflation remains subdued. The challenge will be to calibrate policy carefully
to support that positive backdrop while continuing to move away from the
extraordinary accommodation of the post financial crisis years. However, as a
result of retirements from the Fed’s Board of Governors, there are a number of
vacancies which need to be filled, so the hawk/dove balance could yet shift.
6Fed Action in 2018
According to the Federal Open Market Committee’s ‘Dot Under the plan, the Fed will initially allow US$6 billion a
Plot’ — which indicates each FOMC member’s expectation month in principal from maturing Treasury securities to
of where the fed funds rate will be at the end of each run off. That will increase in steps of US$6 billion each
calendar year — there are three interest rate hikes (of quarter until it reaches US$30 billion a month. For
0.25%) anticipated in 2018. The market is somewhat mortgage-backed securities (MBS) and federal agency
skeptical, with just a half-percentage point increase priced debt, the Fed set an initial cap of US$4 billion. That will
in at the end of 2017, as shown in the Dot Plot below. We increase in quarterly steps of US$4 billion until it reaches
consider three hikes as likely, with increases probably US$20 billion a month. The Fed has not specified by how
coming in March, June and September — this will take the much it plans to shrink its balance sheet, but the bank did
fed funds target range to 2.00%-2.25% by year-end. This say its holdings won’t return to the pre-recession level of
represents continuing normalisation of monetary policy roughly US$800 billion.
after a decade that was arguably anything but normal.
As the Fed begins to wind down its MBS holdings,
In addition to this, the Fed started to shrink its QE-
lenders may find themselves needing to increase the
bloated US$4.5 trillion balance sheet in October 2017,
interest rates they charge to new mortgage borrowers in
having stated it will gradually reduce the reinvestment
order to ensure their securities appeal to other investors.
of proceeds from maturing securities and allow some
to run off.
Fed Dot Plot and Market Expectations (As of 14 December 2017)
Implied FED Funds Target Rate (%)
4.0
3.5
3.0
2.5
2.0
1.5
1.0
2017 2018 2019 2020 2021+
Option Indexed Swap (OIS) DOTS Median Fed Funds Futures FOMC members’ rate expectation
Source: US Federal Reserve, Bloomberg Finance LP, State Street Global Advisors.
Past performance is not a guarantee of future results. Forecasts are based upon estimates and reflect subjective judgements, assumptions, and analyses.
There can be no assurance that developments will transpire as forecast and that the estimates are accurate.
State Street Global Advisors 7Global Cash Outlook 2018
ECB: Still in Accommodative Mode
Although the European economy stepped up a gear in 2017, and appears set for
similarly healthy growth in 2018, the ECB is continuing to provide a
considerable stimulus.
The bank has pledged to buy €30 billion of bonds each month for the first nine
months of 2018, “or beyond if necessary”, in order to “preserve the very
favourable financing conditions that are still needed for a sustained return of
inflation rates towards levels that are below, but close to, 2%.” This is half of
what it was buying in the last nine months of 2017, but it still means that — in
contrast to the Federal Reserve — the ECB’s balance sheet will continue to grow.
ECB Balance Sheet
Billions (€)
5,000
4,500
4,000
Securities held for monetary
3,500 policy purposes (incl. QE)
3,000
2,500
2,000
1,500
1,000
500
0
31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 1 Dec
2010 2011 2012 2013 2014 2015 2016 2017
Gold and gold receivables
Claims on non-euro area residents
denominated in foreign currency
Claims on euro area residents As seen in recent years, attempts to pre-empt central bank actions on tapering
denominated in foreign currency
bond purchases has triggered ‘tantrums’ of varying length and significance —
Claims on non-euro area residents
denominated in euro the closer we get to September 2018, the more ‘jumpy’ market participants
Lending to euro area credit might become. According to the minutes of the bank’s October meeting, some
institutions denominated in euro
Other claims on euro area credit
policy makers have concerns that the open-ended nature of the program could
institutions denominated in euro generate expectations of additional extensions. There were also suggestions
Securities of euro area residents
denominated in euro
that the bank should consider breaking the link between its purchases and the
General govt debt denominated in euro inflation rate.
Other assets
Source: European Central Bank as at 30 November 2017.
8Rate Hike Seen Unlikely
At this stage, it’s difficult to envisage what might happen after September,
but it would take an extraordinary set of circumstances for the ECB to
actually raise rates before the end of 2018. Even a rate increase in 2019
is considered unlikely by the market, as indicated by the forward Euro
Overnight Index Average (EONIA — the average interest rate at which a
selection of European banks lend one another funds with a maturity of 1
day, denominated in euros), below.
Market Sees No Rate Hike Any Time Soon
%
0.00
-0.05
-0.10
-0.15
-0.20
-0.25
-0.30
-0.35
-0.40
Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
2016 2017 2017 2017 2017 2017 2017 2017 2017 2017 2017 2017 2017
EUR EONIA Forward Rate
Source: Bloomberg Finance LP as at 14 December 2017. Past performance is not a guarantee of future results.
Bank of England Bank of Japan
The UK’s headline inflation rate has been above the The Bank of Japan seems unlikely to change its ultra-
Bank of England’s target rate of 2% each month since loose monetary policy in 2018, despite central Bank
January 2017. This underpinned the bank’s rate hike Governor Haruhiko Kurodo expressing confidence in
decision in November even as the UK economy struggled the health of the global economy. He voiced continuing
for momentum amid the looming shadow of Brexit. support for the bank’s policy of yield curve control, the
However, it does not appear that conditions in either the approach undertaken since September 2016; the primary
labour market or the economy as a whole are about to take aim of this was to improve the environment for Japanese
an abrupt turn for the worse. The big unknown is of course banks by ensuring the yield curve is not too flat. The bank
Brexit, and whether the UK’s withdrawal from the EU is has pledged to maintain its accommodative policy until
managed and friendly or messy and hostile. At the end of the 2% inflation target is achieved.
2017, market expectations were for the bank to raise
interest rates by a quarter percentage point in both
2018 and 2019.
State Street Global Advisors 9Global Cash Outlook 2018
REGULATORY
UPDATE
Today’s cash investor operates in an environment that has seen considerable
regulatory change in recent times. Money market fund reform in the United
States transformed the US money market landscape when implemented in
2016, and this coming year will see European regulations finally begin to be
implemented. Europe’s experience will be different from that of the US given
their respective starting points, and the contrasting nature of these markets.
Specifically, the massive US investor switch from prime funds to government
funds is unlikely to be replicated in Europe, not least because of the negative
returns that are typically on offer from sovereign paper.
The underlying purpose of the EU reforms is the same as that in the US
though: to help protect smaller fund shareholders in the event of large
cash withdrawals during periods of heightened volatility.
At SSGA, we have written extensively about the upcoming changes in
Europe’s money market fund landscape as the proposals have charted their
way through the protracted negotiation process. The following is an abridged
version of our latest paper.
1 EU money market
reforms to be 2 Change — But likely
not on the scale seen 3 How reform
may influence
implemented in 2018 in the US fund choice
10Countdown to Implementation
The European Union’s money market fund (MMF)
reforms, which begin a phasing-in process in July 2018,
changes Europe’s cash investing landscape. In advance of
this, investors are studying the new investment
parameters and considering their fund allocation options.
Meanwhile, sponsors are deciding which segments (and
in which currencies) to offer funds in the context of
reform within this €1.2 trillion market.
21 July 2018 21 January 2019
New funds must Existing funds
be compliant must be compliant
MMF
SSGA believes the European Union’s MMF reform will
bolster stability without compromising the investment
potential of money funds. In doing so, we think the reform
will maintain MMFs — and the assets under management
of European MMFs amount to more than €600 billion1 —
as the most attractive destination for corporate and
financial firms’ liquidity.
We believe there is no alternative offering that better
balances the diversification, liquidity and convenience
provided by money funds. Our view is echoed by
respondents to a recent SSGA online survey: 91%
indicated that they intend to continue investing in
THE NATURAL
money funds.2
HOME FOR CASH
As at 20 October 2017. Source: Institutional Money Market Funds Association (IMMFA).
1
EU Money Market Fund Reform Survey Methodology. The survey was presented online to SSGA cash clients in Europe during Q2 of 2017,
2
and completed by 99 senior cash decision makers, primarily headquartered in Great Britain.
State Street Global Advisors 11Global Cash Outlook 2018
Preparing for Change The Four Segments
With the reforms announced and the deadlines now We expect that sponsors will convert existing prime
in place, we have a clearer idea of what to expect as funds into either Low Volatility NAV or Short-term
implementation draws closer. In general, industry Variable NAV funds. We see no fundamental reason for
participants indicate that they will take the changes sponsors to favour one of these two segments over the
in their stride, and that has been the feedback we have other, meaning they are likely to be led by the preferences
also received from discussions with clients. of their clients.
Many funds in Europe’s pre-reform money market We expect that EU-domiciled government MMFs will
landscape already featured variable net asset values almost certainly be converted into Public Debt CNAV
(NAV)* and were subject to restrictions or ‘gates’ on funds, regardless of whether they hold dollar, sterling or
redemptions. A significant proportion of investors are euro-denominated government debt — a transition that
already equipped to handle gates, fees and variable NAVs, we expect will go smoothly.
and are comfortable with them.
Standard VNAV funds are positioned between traditional
We don’t anticipate that investors will react with the MMFs and short-term bond funds. These have longer
extreme caution exhibited in the US, where more than maturity and asset life constraints and less stringent
US$1 trillion in assets were transferred from prime to diversification requirements than the other segments.
government strategies. Moreover, in contrast to the US
experience, we expect reform to have little impact on * T he NAV is simply the price of a share determined by the total value of the
short-term credit spreads. securities in the underlying portfolio, less any liabilities.
Change could be a relatively bigger event for sponsors.
Administering the transition is expensive and time
consuming and there is potential for the reform to fuel
some consolidation within the industry.
LOW VOLATILITY NAV (LVNAV) PUBLIC DEBT CONSTANT NAV (CNAV)
These funds will likely appeal most to investors As the deadline nears, these funds could attract
seeking an option that will maintain a constant NAV in inflows given their pricing rules will not change.
the vast majority of circumstances. Although subject to liquidity-based fees and gates,
these typically invest in high-quality, highly-liquid US,
They will price at a constant dollar, albeit with a lower
British, German and French government debt
tolerance for change: 20 basis points versus the
current 50 basis points. They will be subject to However, short-term EU debt currently offers low or
liquidity-based fees and redemption gates. negative yields, reducing this segment's appeal.
SHORT-TERM VARIABLE NAV (VNAV) STANDARD VNAV
These funds could attract extra AUM from investors The potential to earn additional yield on core and/or
seeking additional yield and wary of the liquidity- strategic cash not needed for immediate operations is
based fees and gates that apply to LVNAV funds. likely to be a key reason investors will consider
allocating to this segment.
At SSGA, we believe that such caution would be
unwarranted.
12Low Volatility Public Debt Short-Term Standard
NAV Constant NAV Variable NAV VNAV
LVNAV CNAV VNAV VNAV
TIME TO CHOOSE
Although less transformational than the reforms
rolled out in the US, investors will still need to make
important decisions ahead of the deadlines. At SSGA,
we will continue to offer a comprehensive range of
fund options and are always ready to help our clients
find the most appropriate solution.
State Street Global Advisors 13Global Cash Outlook 2018
CREDIT
MARKET
OUTLOOK
For nearly two years, we have been describing the current global credit cycle
as “extended”, but there have been a variety of factors that have contributed to
the duration of this cycle. The long period of global monetary policy
accommodation has certainly been a driver, and as such it makes sense to
examine this factor carefully as we head into 2018, since the level of
accommodation will likely decrease materially in coming months.
1 Reduced central
bank purchases to 2 US policymakers to
act if flattening yield 3 Credit conditions
remain benign, but
impact credit market curve threatens top of the credit
in 2018 negative effect cycle appears near
14Conditions Favor Tightening Changing Yield Curve
A withdrawal of accommodation would appear justified We also must consider the functional impact of higher
given the robust macro-economic backdrop, with global short-term rates and the shape of the yield curve. The
growth at its strongest levels since 2010. This creates a curve flattening that has taken place in the US in recent
better operating environment for global banks and months has elicited attention because an inverted yield
corporations and should assuage some concerns around curve has historically been a leading indicator of recession.
the vulnerability of the credit cycle. Still, net central bank
asset purchases at a global level are tentatively expected
to fall by as much as US$1 trillion in 2018. The Flattening US Yield curve
Basis Points
Global Central Bank Purchases 140
Trillions (US$) 130
2.4 120
110
2.0
100
1.6 90
80
1.2
70
0.8 60
50
0.4
Dec Jan Mar May Jul Sep Nov
2016 2017 2017 2017 2017 2017 2017
0.0
2008 2010 2012 2014 2016 2018 2-year 10-year Spread
Source: Citi Research, Haver, Markit as of 24 November 2017.2 Source: Bloomberg Finance LP as at 14 December 2017.
Forecasts (2018) are based upon estimates and reflect subjective judgements,
assumptions, and analyses. There can be no assurance that developments will However, we’d note that historical yield curve inversions
transpire as forecasted and that the estimates are accurate.
that presaged recessions occurred as a result of a sharp
flattening of the short rate expectations component.
Tightening global monetary policy — and the impact of
The recent flattening seems to have been driven instead
cumulative Fed rate hikes in particular — would diminish
by a decline in the term premium on longer-dated bonds.
the opportunity cost of not taking credit and duration
This could reflect a number of factors, including the
risk. Given these conditions, it is questionable as to
continuing net expansion of major central banks’ balance
whether an adequate amount of private funds will be able
sheets (for now) and/or low inflation.
to replace central bank purchases and maintain stability
in the global credit markets and for global asset prices. The Global Cash Credit Research team at SSGA is focused
on the impact that the flatter yield curve could have on
bank earnings and, potentially, the real economy. While it
is not our base case, we will be monitoring whether
tightening monetary policy in the US will, in any way,
choke off credit growth in the system, by making lending
a less profitable endeavour.
Citi Research: European Credit Outlook 2018, page 19.
2
State Street Global Advisors 15Global Cash Outlook 2018
Reasons for Optimism
Despite the aforementioned risks, there are reasons to be optimistic that
global central bank accommodation withdrawal will not cause a confluence
of disruptive events in 2018. In the first instance, it seems likely that major
central banks would cease monetary policy tightening if it became apparent
that financial conditions were negatively impacting growth.
Second, the material improvement in the structure and stability of the major
global banking systems should enable banks to provide support to economies
under most macro-economic scenarios — a positive legacy from the global
bank regulatory reforms instituted in the aftermath of the financial crisis.
This is a particularly relevant point for Global Cash investors, as banks
remain the most prevalent investment counterparties in the short-term
fixed income markets.
Furthermore, there is also the potential for some mitigating circumstances
which could offset any negative macro-economic impacts from monetary policy
tightening — namely, the (partial) reversal of fiscal and regulatory conditions
that have characterised the post-global financial crisis landscape. Following the
onset of the crisis, a considerable amount of fiscal tightening and an aggressive
cadence of financial system regulation were necessary on a global basis.
However, due in part to the success of these global initiatives, the tide is turning
in directions that could serve as a stimulus to the global economy; in particular,
we find this to be the case in the developed markets that SSGA’s Global Cash
funds invest in.
Lastly, it’s possible that marginally higher interest rates (assuming the rates rise
at a slow, measured pace) will be positive for the long-term growth path of the
global economy if it actually steepens the yield curve, improves the operating
environment for banking systems, and/or accelerates the rotation of lending to
more efficient sectors.
Sector Focus
In trying to determine whether tighter global monetary policy will disrupt the
further extension of this elongated credit cycle, we are focused on sectors that
are most exposed to potential negative impacts from higher interest rates.
These include US subprime consumer lending, the US commercial real estate
market (particularly retail properties), China’s banking system, and the
residential real estate markets in Canada, Australia and the Nordic countries.
All of these risks have implications for the global cash credit universe and will
be monitored closely by the Global Cash Credit Research team as we analyse the
impacts from the normalisation of global monetary policy.
16Credit Cycle: Near the Top?
Accurately predicting the length of the current credit
cycle is very difficult, but we are confident that the
global cash markets, and the global financial system,
will be more resilient to downturns than in the past
as a result of the aforementioned developments in the
global banking system.
We believe that most banks in the SSGA Global Cash
Credit investment universe will be more stable
investment counterparties through economic cycles,
but investment counterparty selection will continue
to be important during any credit cycle or
economic downturn.
While fundamental credit conditions for the banking
sectors that are relevant to SSGA’s Cash business
remain benign, we are cognizant that we are at, or
near, the top of the credit cycle. When this cycle
turns, cash investors with exposures to the banking
institutions best equipped to maintain their
fundamental credit profiles in a more difficult
operating environment will likely benefit.
State Street Global Advisors 17Global Cash Outlook 2018
CAPITAL
MARKETS
OUTLOOK
For cash investors, the markets in which they operate are undergoing change.
Some of this is incremental and reflects a natural evolution of financial markets
in reaction to economic and policy changes. Others are more far-reaching in nature,
with implications for investment choice. In the United States, potential adjustments
to Treasury supply volume and duration is significant, as is the Fed’s acceleration
in the reduction of its balance sheet. How the debt ceiling negotiation is managed
early in 2018 is important with additional supply a likely outcome at the end of
the process. In Europe, change is also on the horizon amid regulatory changes
and a slowing pace of central bank asset purchases; but for short-term investors,
conditions are unlikely to change much as negative yields seem set to hold sway.
1 Gradual unwinding
of Fed balance sheet 2 US Treasury to
increase supply; 3 Europe money
market funds to
to avoid market bias towards short remain challenged
disruption duration issuance by negative yields
and Brexit
18Treasury Issuance to Shorten LIBOR — The Beginning of the End?
The US Treasury market is set to become a whole lot A notable new development in 2017 was the
more interesting, with changes beginning to reshape the announcement that the Financial Conduct Authority
market over both the near- and longer-term. In the first (FCA) will not require the banks that collectively
instance, the make-up of US Treasury issuance could determine the London Interbank Offered Rate (LIBOR)
become more tilted towards shorter duration paper than to continue submitting rates past 2021, effectively
has been the case. The Treasury Borrowing Advisory mapping a timeline to its likely demise. The reputation
Committee’s (TBAC) has recommended an increase in of LIBOR had been hit in the aftermath of the global
the supply of two-, three- and five-year securities financial crisis amid allegations of collusion and rate
potentially see a reduction in the issuance of seven- and manipulation in order to make profitable trades or
10-year notes, and 30-year bonds. The TBAC’s suggestion else to give a misleading impression of their
also included an increase in the amount of two-year bank’s creditworthiness.
treasury floating rate notes issued.
The FCA’s timeline recognizes a transition will take
Short-term investors would be expected to benefit from time, but central banks have been identifying alternatives
the extra issuance given this should push those yields to LIBOR that are anchored to actual borrowing activity.
higher than they might otherwise be. An increase in the In Europe, the European Central Bank (ECB) has
supply of Treasury issuance might also drive rates higher favored a move to the Euro Overnight Index Average
in the repo market as more supply on the primary dealer (EONIA), while the Bank of England favors the sterling
balance sheets must be funded. equivalent, or SONIA. Both institutions continue to
research those rates to determine their robustness and
Balance Sheet Wind-Down what else can be done to ensure they best represent the
cost of short-term borrowing.
The Federal Reserve started the wind-down of its
balance sheet in the final quarter of 2017 and this will In the US, the shift to a new short-term funding rate has
continue to accelerate through 2018. Although the Fed not formally begun. This rate, which is preferred by the
ended its bond purchasing program at the tail-end of Alternative Rates Reference Committee (ARRC), is the
2014, it has continued to reinvest maturing Treasuries Secured Overnight Financing Rate (SOFR) and will be
and Mortgage Backed Securities. In the fourth quarter calculated from the average of three rates: Tri-party
of 2017, the Fed did not reinvest up to US$6 billion of General Collateral Rate, Cleared Bi-Party Repo rates and
US Treasury securities and US4 billion of US Agency GCF repo rates. A key attraction is that the combined rate
Mortgage Backed Securities (MBS). This amount will will have tens of billions worth of transactions behind it
increase by US$6 billion and US$6 billion respectively and represent overnight secured funding rates in the US.
each quarter up to US$30 billion and US$20 billion by
the first quarter of 2019, and continue at this level Healthy Supply
beyond then.
The market does not appear concerned about the
This gradual unwind of the Fed’s US$4.5 trillion balance transition away from LIBOR as yet. We have seen a
sheet should not have any near-term impact on the continued healthy supply of LIBOR-based floaters that
money markets and we expect the pace to be gradual mature after the December 2021 deadline; there has been
enough not to disrupt the markets. In the longer term, some speculation that the LIBOR banks might continue
and similar to the aforementioned potential effect of an to submit LIBOR rates even after that date. And therein
increase in supply, this could lead to increased yields in lies is a notable difference — the LIBOR market provides
the repo market as primary dealers will have more debt for term products, while the SOFR (and EONIA/SONIA)
to fund. is by definition an overnight rate; some progress is
required to provide a mechanism that will effectively
allow for fixed terms linked to SOFR. A short-term
curve will likely develop that will facilitate such term
transactions, in a similar way to an Overnight Index
Swap on the federal funds rate.
State Street Global Advisors 19Global Cash Outlook 2018
THE DEBT CEILING AND TREASURY BILL SUPPLY
In the near term, the US will once again be dealing with a Prior to 2008, it would not have been unusual for the US
debt ceiling limit. While all previous debates have Treasury to run over 20% of bills as a proportion of total
concluded with a resolution, there is still the potential for public Treasury debt, as is evident in the figure below. It is
a technical default of a US treasury bill. We should stress unclear if we will move back to this ratio anytime soon.
that this is not our base case. We see it as an extremely
In anticipation of additional Treasury bill supply and the
remote scenario, but it nags at the consistency of US
expectation that those bill yields should increase relative
Treasury bill issuance and how the US Treasury manages
to the federal funds rate, we will closely monitor the
its excess cash. In 2018, consensus estimates indicate an
weighted average life of our government and treasury
additional US$430 billion of new Treasury bill supply.
portfolios to ensure we can capture this cheapening
In a similar way to the shortening duration of US Treasury when it occurs. At the same time, we will be mindful that
debt, this increase in bill issuance should generate higher term premiums could also push higher, with potential
yields versus other short-term benchmark rates. It would implications for the shape of the curve.
also generate a larger percentage of bills versus notes and
bonds. Estimates around bill issuance indicate that it could
increase from approximately 13% of total public treasury
debt to over 15%; this would represent the highest
percentage of debt since early-2013.
Treasury Bills as a Percentage of Total Treasuries Outstanding
Billions (US$) Percentage
16,000 40
14,000 35
12,000 30
10,000 25
8,000 20
6,000 15
4,000 10
2,000 5
0,000 Mar Aug Jan Jun Nov Apr Nov 0
1997 2000 2004 2007 2010 2014 2017
Total Treasury Debt Outstanding (left)Total Treasury Debt Outstanding (Left) Treasury Bill Debt Outstanding (Left) — Treasury Bills as a Percent of Total US Treasury Debt (Right)
Source: US Federal Reserve, State Street Global Advisors as at 14 December 2017. Past performance is not a guarantee of future results.
20CREDIT SPREADS
Restoration of Normality?
The ECB has also done a very effective job in providing
term funding to the region’s banks. The Targeted Longer
Term Refinancing Operations (TLTRO) has allowed the
ECB to enable banks to lock up funding and reduce their
reliance on less-stable funding sources.
US money market credit spreads had a nice recovery in
2017, with the widening experienced amid US money Money Markets Challenge
market reforms in 2016 reversing as the year progressed. Sourcing short-term debt at a reasonable price continues
There was healthy demand at the cheaper levels and to be a challenge for European money markets. The repo
spreads typically reacted nicely by tightening versus their markets have experienced significant dislocations around
benchmark, something that was also evident further out the end of every quarter and the year-end as a result of
the credit curve; even with the corporate bond market dealers withdrawing offerings and market liquidity
seeing record-setting issuance in 2017. freezing up. The ECB has reportedly considered
implementing programs that would be similar to the US
However, the significant decrease in money market prime
Federal Reserve’s Reverse Repo Program, but complexity
assets ultimately limited the extent of the recovery in
around such activity persists. It seems more likely that
credit spreads. By the middle of 2017, the tightening had
the ECB would probably issue some type of short-term
halted and remained stable through to the end of the year.
unsecured debt by the ECB to mop up excess liquidity in
It’s anticipated that credit spreads will remain range-
those periods. This will become more critical when the
bound through 2018, barring any macro-economic
ECB ultimately decides it is time to raise interest rates,
shocks; we would expect the yield spread between the
something we don’t anticipate occurring until 2019 at
prime money market fund and the government money
the earliest.
market fund to remain within its current range (25-30
basis points). For the most part, it appears that prime Credit conditions across Europe improved in 2017 and
funds have ‘normalised’ their duration and liquidity we see this trend continuing in 2018. But even with this
metrics. We don’t expect a substantial shift in liquidity, improvement, the spread between Government and
holdings or duration given our forecast. Prime money market funds has been at historic wide
levels; prime fund yields can be 20-30 basis points higher
than that of a government fund. There are few signs to
“We would expect the yield spread indicate that the differential will not remain in place
between the prime money market fund for 2018. European cash investors will likely continue
to hunt for yield further out the yield curve, as well as
and the government money market further down in credit quality, in order to mitigate the
fund to remain within its current negative returns.
range (25-30 basis points).” Brexit Remains an Issue
The Brexit dynamic underlying the UK market
ensures that uncertainty remains an ever-present
Europe — Supply amid Negative Rates
feature. While the Bank of England in November 2017
In European rates markets, there is arguably the implemented its first interest rate hike in a decade as
potential for some drama in 2018, but we are expecting inflation hovered around the 3% level, the move was
the year to be rather more mundane. The European largely seen as a reversal of the post-referendum
Central Bank’s asset purchase program has created emergency rate cut in August 2016. And it is Brexit and
substantial demand across a range of fixed income painstaking negotiations that remain the key factors for
investments. Yields on short-dated government debt are the UK in 2018. There are so many potential outcomes or
deeply negative in most countries across the European delays that it continues to be challenging to call, with any
Union (EU) — and negative yields persist further out the conviction, what the yield curve will look like in the UK.
curve of many euro sovereigns.
The ECB is continuing its asset purchase program (at a
reduced €30 billion per month) until at least September
of 2018, and considerable speculation persists around the
subsequent steps the bank may take when this program is
ultimately wound down. The program has been
responsible for the significant distortions in term
premiums as is evident by those negative yields and the
€1.8 trillion of excess liquidity held at the ECB.
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