After an initial shock, global financial markets calmed down in the week following the June 24 vote by the British electorate to leave the European Union (Brexit). As leaders from the United Kingdom and EU began a process of separation that could take several years, the immediate impact on institutional cash investors was only mildly negative, principally in the form of lower yield potential from US money markets.
But with less than four months to go before key money market fund reforms take effect, Brexit added to investors’ anxiety over safety and liquidity of their portfolios. For corporate cash investors, we have five immediate takeaways:
- While Brexit will likely have a major political, economic and financial impact on the UK, we believe there will be less of an immediate impact in the US. But look for short-term volatility, and with market liquidity less predictable than before, cash investors should maintain sufficient liquidity in their portfolios.
- Expect more accommodating central bank policies. With the Bank of England and European Central Bank expected to cut rates and expand asset purchase programs, the yield on high quality liquid assets will remain low for months ahead. Expect the Fed to slow down its interest rate normalization process, possibly putting hikes on hold until the second half of 2017.
- With low yields comes the tendency to reach for lower credit quality instruments. Beware of credit risk, as recent waves of mergers and acquisitions and share buybacks have dampened corporate credit strength and increased financial leverage.
- Brexit came at an inopportune time, as US prime money market fund reform is set to take effect in October. This may encourage more flight-to-quality asset outflows from prime funds into other instruments.
- The drop in short-term government yields and steepening of the credit yield curve may create opportunities for separately managed account investors to own high-quality liquid credit instruments further out on the yield curve for attractive return potential.
Money Markets React
The immediate market reaction to Brexit in the US is the reduction of yield in Treasury bills and increased usage of the Fed’s reverse repo facility (RRP). At the same time, both tri-party and inter-dealer repo rates spiked, suggesting the market’s reluctance to lend to financial intermediaries. While the longer end of the treasury yield curve flattened, higher LIBOR rates resulted in a steeper short-term credit yield curve.
Given near-term uncertainty of UK-EU negotiation and the potential spillover effect, we also expect less appetite from US money market funds for commercial paper debt and certificates of deposits issued by institutions domiciled in the UK and, to a lesser extent, the EU. This reduction is on top of the already reduced appetite for non-government issuers as the October money market fund reform deadline approaches.
In short, the end state of a Brexit may take several years to materialize and the negotiation process will likely be long and complicated. We expect many twists and turns from both the UK and EU sides. In the meantime, financial markets may face policy uncertainty, economic malaise and market volatility. Institutional cash investors in the US should be able to navigate the uncertainties by managing liquidity carefully and keeping their eyes open for new credit risks.
For a more detailed analysis, download our new research report on Brexit: What Happens Next and How it Impacts Institutional Cash Investors.