Key Highlights

• Repo will look flush as MMFs face dwindling T-bill supply
• Recent 10y yield softness due to waning Fed expectations
• Credit risk appetite is close to turning

Money funds running out of T-bills to buy

EXHIBIT #1: COULD WE SEE AN INCREASE IN REPO ALLOCATIONS?

^{Source: Crane Data}

Our take

Money market mutual funds (MMFs) hold record amounts of assets. The Investment Company Institute shows holdings across the complex of $6.97trn as of last Wednesday. The Crane Data figures, which includes a slightly wider universe of funds, reports $7.32trn. Presently, the majority of MMF holdings are in either T-bills (43% of total assets) or repo (35%), with 21% in other assets like commercial paper, certificates of deposit, or agency securities.

Exhibit #1 shows the asset allocation of MMFs and its evolution over the past 6 years. Note that between April 2021 and May 2023, these funds flipped their asset allocation from largely T-bills to increased participation in repo. Part of this move was the large (-$675bn) decrease in bill issuance between March 2021 and May 2023 as COVID stimulus payments no longer needed financing. In addition, two debt ceiling episodes occurred between 2022 and 2023, with the latter going to nearly the 11^th hour at the end of May 2023.

Forward look

Asset allocations are fairly indifferent at the moment, even with creeping debt fears and building consensus around a late July X-date. Bill supply is running net negative because of the debt limit. We expect MMFs to decrease their allocations to Treasurys and increase exposure to repo. While the debt ceiling continues to be an issue, we expect repo to appear flush, thanks to MMF cash and lack of bill of supply, as well as the rise in reserves coinciding with the decrease of the Treasury General Account.

10y yield decompositions show Fed expectations now at play

EXHIBIT #2: INFLATION EXPECTATIONS NOT DRIVING YIELDS

^{Source: Federal Reserve Bank of New York, Bloomberg}

Our take

Exhibit #2 shows major movements in the 10y yield from mid-September 2024 to now. We identify four distinct periods of increasing and decreasing yields. When yields were surging to 4.5% or more, we were arguing that most of this pickup in yields was due to real factors, evidenced by the concurrent increase in the treasury term premium.

In the September through November episodes, much of the increase in yields was driven by a repricing of the 2y note, a good proxy for medium term monetary policy expectations. However, in the subsequent two periods, the 2y yield did not move nearly as much as the 10y yield or the term premium. The move lower in yields from mid-November to early December was more driven by declining term premium than by the changing policy expectations, as was the case with the move higher between early December and mid-January.  The most recent move lower since mid-January has been due to both declining 2y yields and falling premia.

Despite talk about tariffs leading to inflation (something which we are not entirely in agreement with), inflation expectations have not played a significant role in movements of the 10y yield. We have discussed the fact that short term (1- or 2-year horizons) inflation expectations have moved up due to tariff risk , but beyond about 5 years (and certainly 10 years), such expectations haven’t moved much, if at all.

Forward look

We have been calling for 5% yields on the 10y note, based on expected large coupon issuance later in the year to finance massive tax cuts and waning demand to fund large deficits. However, we acknowledge in the short-to-medium term, the pressure on yields is likely lower and not higher. Weakening growth, perhaps exacerbated by a troubling trade war, should keep the pressure on Fed pricing and keep yields on the back foot.

Credit risk appetite waning

EXHIBIT #3: HY-IG FLOWS AND HY-IG SPREADS

^{Source: Bloomberg, iFlow}

EXHIBIT #4: NY FED AND IFLOW MEASURES ARE SIMILAR

^{Source: Federal Reserve bank of New York, iFlow}

Our take

Credit spreads have risen slightly, albeit from extreme tights. Related to the general – and so far, marginal – deterioration in the growth outlook, we think that spreads might have seen their tightest in this cycle. It appears that risk appetite by real money investors for corporate bonds has plateaued.

We can examine corporate bond flows by credit score and can specifically compare flows into high yield bonds as opposed to flows into investment grade paper. Taking the difference in HY and IG flows gives us a proxy for general risk appetite for corporate credit. As Exhibit #3 shows, there is a loose but clear (and intuitively appealing) relationship between this measure of credit risk appetite and corporate spreads. In particular, the nearly 40bps worth of tightening in the HY-IG spread between the end of 2023 and the middle of 2024 coincided with a surge in the spread between HY and IG flows.

The New York Fed has started publishing a Corporate Bond Market Distress Index, for all bonds, IG bonds, and HY bonds. If we take the difference in the IG and HY distress indices and plot them against our credit risk appetite proxy from iFlow (Exhibit #4), we can see that falling HY flows relative to IG flows match up with rising HY distress.

Forward look

Spreads continued to grind tighter, even as our proxy measure for credit risk appetite stayed relatively range bound. Still, since August 2024 HY flows have steadily outpaced IG flows, suggesting a tighter spread environment. However, this flow differential is currently quite small and slightly positive. If we see it narrow further, we think corporate spreads will have seen their tightest. We’re already seeing some small widening in credit spreads and expect it to slowly continue.