How many credit cheerleaders are on the sidelines?

The quantity of cash parked in money market funds has been at the forefront of investors’ minds for some time now. The surge of inflows for these short term risk-free instruments as rates rose was no surprise considering they now yield more than a single-B rated high yield corporate was offering just a few years ago. However, with the cutting cycle now in full swing after the Fed’s 50bp cut last week, could this trend be about to revert?

Total assets in US money market funds have risen by 40% over the last two years to $6.3tr, but that trend has slowed this year with around $180bn coming in year-to-date, far short of the $500bn+ of inflows seen across the whole of 2023. Meanwhile, US bond funds have benefitted from money markets’ dip in popularity, with over $120bn of inflows year-to-date after two consecutive years of negative flows.

Similar trends have been seen in Europe and the UK. The “Deposits of Euro Area Residents” component of the European Central Bank’s monetary aggregates report climbed to €8.5tr last July, up from around €7tr just before the pandemic, though the pace of the increase has cooled off. At the same time, data from JP Morgan suggests European investment grade bond funds have enjoyed inflows of €30bn this year, with €7.5bn more into European high yield. We have certainly felt this on the desk, with huge order books seen across the board in September’s new issuance season. Last week a euro bond from CPI Property Group was six times oversubscribed, while Nationwide’s recent sterling Additional Tier 1 (AT1) was five times oversubscribed.

We can expect this trend of money market deposit flows slowing (or eventually reversing) to continue as the rate cutting cycle progresses. With market pricing suggesting that by this time next year the Fed Funds rate will be around 3% and Eurozone and UK base rates will be around 150bp lower than they are now, investors will have to look elsewhere to fulfil their return objectives, and we believe the normalisation of the yield curve will only quicken this rotation into bonds. With a heavily inverted yield curve in recent times, it has been a tough ask for investors to switch out of short dated instruments paying 5.5% to a longer dated instrument yielding just 3.5%. However, this dynamic is changing with the closely watched 2s-10s US Treasury curve now at +19bp having been as deeply inverted as -110bp last year.

The question now is how much of this cash on the sidelines will come into the bond market. The vast majority of the shift thus far has been, as expected, into higher quality government and investment grade bonds. Nonetheless, barring any significant deterioration in the macro outlook we expect growing appetite for high yield assets. For reference, the size of the US high yield bond index is around $1.3tr; if only a very small portion of the money market stockpile were to enter that market it could offer significant technical support for prices. Perhaps even more importantly, the cash on the sidelines could act as a floor for any sell-offs we see, thereby reducing volatility.

It is no secret that credit spreads are currently slim, with US high yield spreads only 26bp away from their recent tights and European high yield spreads 80bp away. However, higher overall yields mean credit still looks attractive at these levels and they should help to boost excess returns in credit over the medium term. It is also important to highlight that spreads historically spend the majority of the cycle below their averages, since late cycle periods with tight spreads can persist for years while short-lived spikes in spreads drag up the average. The Fed’s recent suggestion that it is ready to move fast in its cutting cycle if it detects any “worsening” in the economy, along with the money market fund technical, could mean we are in for an even longer stretch below average spreads this time around.

It must be said that there are still some areas of uncertainty, chief among them the US labour market, geopolitical risk, and a seemingly faltering recovery in certain countries in Europe. Subsequently, we still believe portfolios should be balanced and skewed towards higher credit quality, especially considering the compression in spreads we have seen. However, if more clarity prevails in those areas then there is good reason to think the credit cycle can continue for some time yet, with fixed income and particularly credit continuing to perform well for investors.