Money Markets Face Adverse Effects If Fed Cuts IOER

There are expectations across the market that a stimulus measure the Federal Reserve might announce next week will end up hurting investors in the very economy it's trying to revive.


Some market participants expect the Fed, in its two-day policy meeting starting Tuesday, to try bolstering the economy by announcing a reduction or complete elimination of the interest it pays banks for storing excess cash at the central bank. Goldman Sachs said there's a 50% chance this will happen.

The goal is to push banks to start lending and get the economy flowing. But analysts say lowering the interest on excess reserves, or IOER, will end up adding pressure to already ultra-low investment yields, in turn hurting money-market funds that are struggling to generate returns.

"Lowering the IOER is a double-edge sword," said Sean Simko, fixed-income portfolio manager at SEI. "It should help promote lending, however, have an adverse effect within the money-market arena."

U.S. businesses and consumers' appetite to borrow still hasn't fully recovered since the 2008 financial crisis. That's left banks flush with cash, which they don't want these days. Not only will they earn less for their reserves if the Fed slashes the IOER, they'd also face higher fees for holding more deposits because of new FDIC guidelines.

This will likely force investors into other safe, short-term investments to try scraping together some type of return. Cash would flood the money-market space, pushing yields down and compromising the already-paltry returns money-market funds make and their ability to pay the costs associated with running these funds. Some Federal Reserve officials have expressed concerns about this.

"If the Fed eliminates the rate they pay on excess reserves, that means there are billions of dollars more that will go into short-term investments," said Scott Skyrm, global head of money markets and repo at Newedge USA. "More cash means lower rates."

A bulk of this money will be targeted at Treasurys--already a hot ticket asset in the market--which will squeeze the securities repurchase, or repo, market, a vital hub in the financial system. Repo-market participants borrow cheap short-term cash by putting up some form of collateral, usually U.S. Treasurys. So if more banks are buying U.S. debt and not recycling it back into the market, there will be less of it to make the repo market function.

"Faced with paying a fee on deposits, some investors might see the better economic choice as accepting a negative yield on repo," Dave Sylvester, head of Wells Fargo Advantage Money Market Funds.

Sylvester says that eliminating the IOER could also prompt big banks to join Bank of New York Mellon in imposing deposit fees on those who hold large sums with the bank. BNY Mellon announced in August that it would charge 0.13% on depositors that have accounts with an average monthly balance of $50 million "per client relationship."

Fund managers and analysts say that foreign banks with branches located in the U.S. will ultimately be the beneficiaries. They're not subject to the new FDIC charges so reserves might get sent their way. On the other end are money-market funds and the nation's savers, who face choosing between getting zero to negative returns on short-term investments or pay a fee to park their cash in banks just to keep their money safe.