Less Than Zero

How next week’s Fed interest-rate cut will jostle $2 trillion in money-market investments.

Next week, the Federal Reserve’s Federal Open Market Committee is expected to cut the federal funds rate from its current peg of 1.25 percent. The only debate is whether Greenspan & Co. will drop it 25 basis points (to 1.00 percent) or 50 basis points (to .75 percent).

Such a cut is supposed to do what the Fed’s 12 other cuts since January 2001 were supposed to have done: reduce borrowing costs, stimulate the economy, and encourage investors to move cash out of low-yielding bonds and into stocks. The Fed is taking interests rates to depths unseen. Not only do the rates raise the danger of a liquidity trap and deflation, the coming attempt to lower the rates could jeopardize a crucial but frequently neglected $2 trillion corner of the investment world: money-market mutual funds. As Greg Ip notes in today’s Wall Street Journal lead, “too low a rate would imperil money-market mutual funds, for instance, because they might no longer clear enough money to cover expenses and pay a return to investors.”

Money-market mutual funds trace their origins to the early 1970s. At a time when banks were barredfrom paying out market-rate interest on savings, money-market funds could protect investors against the ravages of inflation by purchasing high-yielding, highly secure short-term debt instruments: three-month Treasury bills, municipal bonds, and commercial paper—short-term borrowings liberally employed by corporations. By 1981, when they offered average annual returns of 16.8 percent—thanks to then-Fed Chairman Paul Volcker’s drive to rein in inflation by jacking up short-term interest rates—total money-market fund assets rose to $187 billion, then tripled to $500 billion in 1990.

As a rule, money-market funds today guarantee investors’ principal and offer returns that tend to mirror very closely the federal funds rate. Like all mutual funds, however, they take expenses—for trading, administration, salaries—out of net returns. According to iMoneynet, the average gross yield on assets held by money-market mutual funds is 1.27 percent. But with expenses eating up an average of 59 basis points, the average annual return is a paltry .68 percent. In other words, expenses eat up nearly half of the already paltry returns.

But even these pathetic returns haven’t caused the largest money-market investors to liquidate their accounts. Over the past few decades, treasurers at corporations and governments alike grew more sophisticated about cash management, seeking ways to garner a few basis points of extra revenues. And so they became accustomed to sweeping cash on hand—taxes that have been paid, weekly sales, cash received for an acquisition—into money-market funds. Those short visits are still enough to earn real cash for the institution.

Individuals also use money-market funds as vast parking lots for cash—and many may do so unwittingly. If you have a brokerage account at, say, Fidelity or Charles Schwab, your uninvested cash is most likely invested in a money-market fund. In recent years, well-off people have increasingly shunned banks—which don’t pay interest on checking accounts and pay truly miniscule interest on savings—in favor of cash-management accounts at brokerage firms like Merrill Lynch, which offer checking, ATM privileges, and money-market interest rates.

These two trends have made the money-market fund asset base less yield-sensitive. People just didn’t notice that their returns were rising in the good years because they were focused on their marvelous stock yields. And they are no more attentive to today’s shrinking money-market returns since their stock investments are infinitely more disastrous. In the 1990s, even as money-market returns declined in absolute terms (as interest rates fell) and in relative terms, compared to the returns generated by the Standard & Poor’s 500, money-market funds continued to attract new cash. As Money Fund Report Editor Peter Crane notes: “Money market mutual fund assets and stock fund assets are highly correlated. A rising market and a rising economy puts more assets everywhere.” Total money-market fund assets rose from $763 billion in 1995 to $2.238 trillion in 2000.

So far this year, as returns have drifted toward zero, investors have yanked about $125 billion out of money-market funds, or about 5 percent of total assets. Will the withdrawals accelerate if interest rates—and money-market fund returns—fall further?

No panic is imminent. It takes a few months for rate cuts to filter into money-market accounts. And the large institutions that sweep unused cash into money-market funds don’t have many appealing alternatives. But if the economy doesn’t respond to the Fed’s medicine quickly, and if rates stay where they are for several quarters, we’ll be in uncharted territory. Faced with the prospect of either eating expenses or reporting negative returns—taking more from clients in fees than they earn in interest—money-market funds may choose simply to return investors’ money and close up shop. Or they may seek to goose returns by taking on more risks by using derivatives—an effort that frequently ends in tears. Or companies, governments, and wealthy individuals may again resume parking cash in banks. And that could spell trouble for the $1.3 trillion commercial paper market.

Peter Crane suggests that money funds buy 40 percent of all the commercial paper issued. Commercial paper—essentially an IOU—is the easiest and most hassle-free way for large companies to obtain short-term credit. But if the money that overwhelmingly funded commercial paper moved to bank accounts from money-market funds, companies would be forced to turn to banks for short-term debt. Bank credit is generally more expensive and filled with more hassles than commercial paper.

What a blow it would be to the Fed if reducing interest rates to 45-year lows winds up increasing borrowing costs for businesses it’s supposed to benefit.