MMF Assets Hit Record Highs, Unlikely to Quickly Shift to Risk Assets
Assets under management (AUM) in U.S. money market funds (MMFs) reached a new peak last week at $6.56 trillion. Despite market expectations of policy easing increasing—with a 95% implied probability of a 25 basis point rate cut in September—MMFs continue to see inflows. Many financial analysts believe that the substantial AUM in MMFs represents capital poised to be invested in riskier assets, particularly equities. The rationale is that the current policy rates and resulting high money market yields have led to this accumulation. Once policy easing begins and yields decline, it's expected that these funds will flow into riskier assets like equities. However, it's important to manage these expectations.
Looking back, MMFs have experienced net inflows of approximately $2.6 trillion since the end of 2019, occurring in three major phases. The first phase coincided with the onset of COVID-19, where institutional inflows surged by about $1 trillion in a matter of weeks due to economic uncertainties, despite the Federal Reserve lowering rates to zero. The second phase, driven by retail inflows, began when the Fed started raising rates in 2022, although initial months saw a decrease in institutional inflows. The third phase occurred during the regional banking crisis in March-April 2023, with both retail and institutional investors moving funds from regional bank deposits to MMFs. Inflows have slowed recently, with a slight dip in April likely due to seasonal tax payments.
Looking ahead, we anticipate that MMF AUM will not quickly revert to pre-COVID levels (around $4 trillion), even if policy easing starts in September, as predicted by our economists. They forecast three 25 basis point rate cuts in 2024 and four in 2025, resulting in a soft economic landing and a shallow rate-cutting cycle with the Fed halting at 3.75%. Consequently, money market yields are expected to stabilize around this level, remaining attractive compared to cash alternatives. In the event of a hard landing, the Fed would likely implement more significant cuts over a shorter period, prompting investors to seek liquidity and safety, thereby increasing allocations to MMFs rather than alternatives. This pattern aligns with past stress periods, such as the 2008/09 financial crisis and the initial COVID-19 outbreak in 2020.
Additionally, MMFs can mitigate the decline in their yields by extending the weighted average maturities of their portfolios, locking in current yields before the rate-cutting cycle begins. This makes MMFs more appealing compared to short-term bank CDs and Treasury bills, whose yields decline in tandem with rate cuts. This relative attractiveness accounts for much of the lag between rate cuts and the peak in MMF AUM, which typically averages around 12 months.
It's also crucial to differentiate between institutional and retail MMF flows, as their motivations differ. Institutional funds constitute 61% of MMF AUM, with retail funds making up 37%. When reallocating from MMFs, institutional investors are more likely to move towards high-quality, short-duration fixed income assets rather than riskier assets like equities. A survey by the Association for Financial Professionals found that maintaining elevated cash balances and prioritizing safety over yield were the main themes in organizations' cash investment policies. Retail investors, a smaller segment of MMF AUM, may have a greater propensity to shift towards riskier assets.
In summary, while MMF AUM has significantly increased in recent years, it is expected to remain high even with policy easing. The shift towards risk assets is likely to be gradual and limited, suggesting that the 'money on the sidelines' may not be as beneficial or immediate for risk assets as some predict.