Collateral Damage From Fed Policy (3) – Money Market Funds, A ‘Powder Keg’?

In March 2022, the Federal Reserve began raising interest rates more aggressively than at any time in the last 40 years.

This speed and severity of this policy may not have had much effect on inflation, but it has inflicted significant collateral damage on several sectors of the economy. In my previous column, I examined the impact of the rate storm on the housing market. Here the focus is on another multi-trillion dollar segment of the financial system, where rising rates may be distorting the market and creating new systemic risks: Money Market Funds.

The Cash Problem in the Economy

Enormous piles of cash are accumulating in many corners of the U.S. economy, and that’s not necessarily a sign of health. One worrisome reservoir of liquidity in particular has boomed: money market funds. By the end of 2023, the total value of this asset class reached a record $6.4 Trillion – equal to 23% of the U.S. Gross Domestic Product (GDP).

This “Wall of Cash” (as the Wall Street Journal called it) is divided into two segments: retail (sold to individual investors with certain limits and quasi-guarantees), and institutional (sold to professionally managed investment funds, such as pension funds, insurance companies, hedge funds, etc.). The institutional component accounts for three quarters of the total, and has grown a bit faster than the GDP. It is up about 15% since the beginning of 2022.

But the real action is in the retail component which, while smaller, has seen explosive growth, rising 76% in the last 20 months –

Is this all to the good? Are consumers simply exercising thrift and prudence? Perhaps. But what is the impact on the banking system? What are the implications for equities? Or for other parts of the financial system (e.g., Treasury bonds)?

The surge in money market market funds is a rising tide of uncommitted liquidity, essentially equivalent to cash, parked in a holding tank, movable at a moment’s notice. We have seen in recent crises (most recently the Silicon Valley Bank crack-up) that modern financial technology now enables cash to move much more quickly than ever before.

Three broad questions arise in the connection with this multi-trillion dollar cash build-up:

1. What triggered this sudden surge?
2. Where did all this cash come from? If one pocket is full to overflowing, some other pocket must be emptying out.
3. What will happen when these funds do flow back out of the money market accounts? Where will they go, who will benefit, and who might be harmed?

1. The Trigger

The answer to the first question is simple, clear, and certain. The inflows into retail money market funds began in mid-2022 after the Federal Reserve began raising interest rates. Money market fund levels, lagged by about 6 months, correlate 99% with the Fed Funds Rate. This is the first and most important link in the chain of causality.

2.Where Did All That Cash Come From?

The trillions of dollars that have ended up in these money market accounts took a multistage journey to get there. Much of the cash originally came from from the stimulus programs enacted during and following the Covid-19 pandemic. But it did not immediately go into money market funds. Between Jan 2019 and April 2022, money market accounts increased only about $150 Bn. Most of the stimulus money was first parked in consumers’ personal savings accounts, as deposits in the commercial banking system. Banks added $5 trillion in deposits, more or less equal to the $5 trillion distributed in the post-pandemic stimulus programs.

But that changed when the Fed began hiking up interest rates. Commercial deposits peaked and began to decline at almost the exact moment that the Fed started its interest rate blitzkrieg.

From April 2022 to February 2024, banks saw an outflow of $767 Billion dollars from their deposits, while money market funds took $769 Billion. Another link in the causal chain that looks pretty solid.

These outflows were not without consequence. Depositor withdrawals played a key part in undermining many smaller banks, and in the demise of several (e.g., Silicon Valley Bank). That will be the subject of a future installment in this series.

Where Will It Go Next?

What makes a highly liquid position valuable – the ability to redeploy it quickly (indeed these days almost instantaneously) – is also what makes it dangerous.

When trillions of dollars can move from one corner of the financial system to another almost overnight, it becomes a source of uncertainty and…