The Canary in the Coal Mine: Money Market Funds and Why Equities are Poised to Drop

Hola fellow regards,

Today I am going to dive into Money Market Funds, a topic that recently grasped my attention after a back and forth with one of our own, u/InterPeritura , compelled me to produce a write up of the current assumptions and overall misunderstandings involving this type of investment instrument as well as interest rates in general. Ultimately, this post is meant to elucidate why Money Market Fund Assets increasing during ATHs for equities is a harbinger of coming economic (both monetary and financial) distress.

If you already know what these are, please feel free to skip to "Times when money market fund assets increased while equities increased" section of this post.

What is A Money Market Fund?

To begin, I want to talk about what a Money Market Fund is not. It is NOT a Money Market Account. The difference between the two is that a Money Market Account is insured by the FDIC up to $250K, offers rates that are typically higher than typical savings accounts, and is more accessible than funds kept in the MMF. 

Money Market Funds in contrast buy short term debt-based securities, cash or cash equivalents such as CDs and BAs (bank acceptances), and commercial paper. They can also participate in the repo market which adds another level of complexity to their composition structure and overall risk profile. They are NOT FDIC insured so there is no guarantee of principal.

A MMF is also NOT a Mutual Fund. A Mutual Fund is NOT restricted to regulatory determinations to hold a large amount of low-risk fixed instruments like government or municipal bonds. Mutual Funds can buy equities and corporate bonds, making them higher risk with higher reward. 

Citation: https://www.investopedia.com/money-market-account-vs-money-market-fund-whats-the-difference-7557816#:\~:text=Money%20market%20accounts%20and%20money%20market%20funds%20are,in%20an%20MMF%20is%20insured%20by%20the%20SIPC.

Who invests in Money Market Funds?

Anyone can invest in the Money Market by directly buying the fund or indirectly through the securities that these funds buy which are primarily short term “liquid” assets with low risk of default. The typical MMF investor is likely buying into the fund in order to decrease risk in their portfolio during times of market uncertainty. However, many people overlook the glaring regulatory issues surrounding commercial paper being used as acceptable means of money market fund composition but that's a topic for another day.

MMFs can buy commercial paper and other securities and use those as collateral for other borrowings in overseas and onshore monetary facilities. Individual investors cannot participate in buying Non asset backed commercial paper. (You shouldn't want to anyway). Meaning banks and high credit financial companies can use unsecured commercial paper in repo operations with MMF managers who themselves are typically part of a financial institution. (Not with the FED but in the private repo market between intermediary financial entities like offshore banks and financial corporations). 

Citation: Sec3(a)(3) of the Securities Act; FED1

Times when money market fund assets increased with equities (Hint: it's the opposite of “outgoing procession”) 

Now that the background information on what MMFs are and how they operate have been clarified somewhat, I will now present data showing why increases in money market participation alongside increasing equities is actually a sign of trouble to come. 

Current contemporary retail misconceptions: 

1. Interest rates falling make money market funds less attractive.
2. Dropping interest rates makes money market fund participants switch to investing in equities. 

The above two assumptions are the reasons why I made this post. This is because the above assumptions are wrong. They exist as a direct result of misinformation regarding why investors use these funds. The reason investors use money market funds, especially government and treasury type MMFs, is due to a desire for having cash in a liquid market where it will earn returns relatively risk free in lieu of better investment opportunities elsewhere.  

Now ask yourself: “why would decreases in interest rates be linked to less participation in MMF and more money in equities?” The answer is….it doesn't. Interest rates in the short term (not long term), as we all already know, are influenced by FED policy. And by now we should know that the FED is primarily concerned with price stability and keeping unemployment low (how well they perform these duties is debatable). So, if central bankers are considering cutting rates, this means that current macroeconomic conditions are unfavorable for either one or both of the above-mentioned FED mandates. Poor economic future outlook is NOT a boon to equities, which should be obvious.

 Basically, MMFs exist as a facility for investors to use to park cash while they wait for better opportunities in the market. Their main pros are high liquidity and low risk. Liquidity and risk management are the reasons money market funds of this type are used.  We only need to look at 3 graphs to show us that money market funds increase in their attractiveness as economic conditions become more volatile and uncertain and only begin to decrease after the equities market bottoms out which will be used as our proxy for sentiment changes. 

Exhibit A: Dot Com Bust

Leading up to the dot com bust, the fed funds rate started at 6.5 % in Q3 of 2000 and ended at 1.7% by Q3 of 2002 after the end of the recession. Picture 1 (blue line is 6.5% while red is 1.7%) 

Picture 1 (blue circle is 6.5% while red is 1.7%) 

Despite interest rates lowering, Money Market Fund Assets continued to increase and did not begin to decrease…. until the recession was over. At the same time the S&P 500 went from $2592 in Sept of 2000 all the way to $1412 by Sept 2002

Arrows are color coded to correspond with fed funds rate during the period discussed.

Arrows are color coded to correspond with fed funds rate during the period discussed.

Exhibit B: Global Financial Monetary Crisis

The date is September 6th, 2004. The federal funds rate is sitting at 1.48% (green circle). Three years later, on September 10th, 2007, the fed funds rate was 5.25% (orange circle)

pic#4

During this time, money market funds did, in fact, increase in net assets (See pic #5). However, in 2008 when the GFC was well underway, Bernanke slashed rates all the way to 0.15% by Sep 7th, 2009 (purple circle). Yet, despite the lower yield on money market funds during this time, net assets increased until they peaked in Q4 of 2008 and remained relatively level until Q2 of 2009 (See purple line in pic #5). 

#5: MMF assets INCREASED while rates were lowering in the recession (shaded region)

This decrease in Money market fund net assets coincided with the bottom in equities that same year. Money remained “sidelined” until macroeconomic confidence was restored. (See pic #6). 

#6 Purple line in pic 5 and this pic show that sentiment change in the equities market corresponded with decreasing MMF utilization

Are we seeing the pattern here? Money Market Fund utilization is not tied to interest rates. They are tied to macroeconomic conditions and sentiment. MMFs are increasingly used when macroeconomic sentiment and outlook begins to increase in uncertainty and typically reach highest net asset values when sentiment around equities change. They are NOT tied to interest rates.

Exhibit C: Covid Lockdown Recession

Many people forget that, prior to COVID, macroeconomic sentiment was leaning toward a weakening economy and a looming, but slightly obfuscated, recession. Again, same pattern with economic uncertainty increasing and Money Market Fund net asset values increasing while equities rise. 

In response to anticipated macro weaknesses, Powell began to cut rates halfway through the Q3 of 2019 starting from 2.41% in July of 2019 all the way to 1.55% by November of 2019(See picture #7). 

Pic #7. Red dot is 0% interest rates in March

However, during the last half of 2019, MMF increased in net assets despite the decreasing interest rates(See picture # 8). 

Pic #8 :Increasing MMF utilization alongside decreasing interest rates

All of this occurring while equities reached ATHs in December and would tread water until Covid in late february/early march caused mass selloffs (See picture #9).

pic #9: Between black and green lines, S&p increased while MMF asset increased (See pic#8)

The unprecedented monetary and fiscal stimulus policies and packages make this data series harder to interpret. However, we can infer that the V-shaped recovery in equities following the intervention from the FED that wiped out many veterans in this sub was indicative of a sentiment shift. Again, MMF net assets corroborate this relationship with sentiment being the deciding factor as net assets began to decrease and level off until late 2022 and early 2023 when they began rising again…the same year everyone was expecting a recession to occur. 

Conclusion

In summary, if there was a causal and directly proportional relationship between interest rate levels and MMF net assets, there would not be so many instances of money market funds being over utilized during periods of interest rate cuts. MMFs are primarily utilized by private investors, institutions, and companies to manage risk while keeping capital in highly liquid assets in uncertain market climates. NOT for the enticing interest rate. 

TLDR?: There is no observable correlation with money market fund asset increases corresponding with rises in equities later. This means cash in those instruments are not used later on in equity markets but primarily to keep current cash liquid and earning interest to a relatively safe degree. Powell cutting interest rates is a sign that a recession is already underway and will be a time when market sentiment will be at their lowest and most uncertain, MMFs will actually be increasing in net assets while equities fall.

Positions? I am currently building a QQQ short position in LEAPs with strike prices in the mid 300s. Will update once it is above $10k

Thoughts?