Effective Fed Funds and Money Markets

The weighted average of the Fed funds rate has edged higher. Following the Fed hike in December 2015, the Fed funds average around 36 bp in January before moving into a 37-38 bp range. However, since the UK referendum it has been trading consistently around 40 bp.

The Fed fund futures contract settles at the average effective Fed funds rate for a given month, not at the policy rate. Ahead of next week's FOMC meeting where practically no one expects a change in policy, implied yield of the July Fed funds futures contract is 40.25 bp.

Some dealers think that one of the factors that are keeping Fed funds firm is the preparation of changes to the US money markets as of the middle of October. Institutional money markets that invest in a range of short-term instruments including commercial paper will be required to have a floating NAV, which is to say that the price will not be constant at one dollar.

In addition to a floating NAV, prime funds will be able to impose liquidity fees and redemption gates if the funds liquidity fell below 30%. At the end of the first week in July, the average weekly liquidity of prime funds was 53.4%. Reports indicate that four prime funds had liquidity below 35%, but none were below 30%.

Besides these prime funds will be money market funds that invest only in government paper. They will still have a constant NAV, though the yield will be a little less than the prime funds. Many institutions who use money markets (think businesses or asset managers) will prefer the fixed NAV. Capital preservation is more important than return for those funds.

On the surface, it appears that there has been a huge liquidation of prime fund assets and a move into government money markets. One set of figures suggests that the prime funds have seen an outflow of nearly a third of their assets, leaving about $1 trillion, as of early July. However, a little more than half of the outflows appears to be prime funds converting into government only funds.

Prime funds have been preparing for withdrawals so as not to trigger the liquidity rules or the redemption gates. As a consequence, they reportedly a running larger cash balances and have reduced their average maturity. In June it stood at 29 days compared with a 41-day average maturity of government money market funds.

A consequence of a higher effective Fed funds rate is that it decreases the implied chance of a rate hike in the Feds funds futures market. Assuming that Fed does not hike next week, what are the odds of the September move. The September meeting is late in the month (September 21). Therefore it may be more helpful to look at the October contract. Assuming no hike, fair value would be where Fed funds are currently trading, namely 40 bp. Assuming a hike, fair value would be 62.5 bp. Currently, the October contract is implying 44.5 bp or about an 18% chance of a hike.

The November 2 meeting is too close to the election to be live. The December meeting is possible, like last year. The December meeting is on the 14th. A rate hike then would make fair value for the December contract near 52 bp yield. It is currently implying 48 bp yields or about a two-thirds chance of a hike then.

The string of better than expected US data encouraged a reassessment of the trajectory of Fed policy, though we will feel more comfortable when the Fed's leadership provides updated guidance, post-Brexit. At the same time, expectations for easier BOJ, BOE, RBA, and RBNZ policy over the next several weeks have increased, and nothing Draghi said today closes the door on new initiatives as early as September.