Rush into money market mutual funds also caught US Federal Reserve by surprise

US Federal Reserve has moderated its hawkishness on interest rates. It increased interest rates by 25 basis points yesterday. This happened just a few weeks after US Federal Reserve Chairman Jerome Powell had said in his testimony before the US Congress that there is still need for continuing with aggressive increases in interest rates. The banking crisis has caught Powell and Federal Reserve by surprise.

The Federal Reserve clearly overlooked the negative impact that successive increases in interest rates would have on the value of existing bonds of banks. Value or price of existing bonds go down when interest rates go up. The losses that Silicon Valley Bank suffered on its bond portfolio was one of the reasons that triggered its collapse and the banking crisis.

Another thing that seemed to have caught the Federal Reserve by surprise is the withdrawal of deposits from many banks because of the rise in interest rates. Banks were slow to increase the interest rates that they paid on their deposits when the Federal Reserve raised interest rates. So a lot of customers, especially the corporate ones, withdrew money from their bank deposits and put them in money market funds. These money market funds immediately offered a higher rate of return when the Federal Reserve increased interest rates. 

 Money market funds invest in government and corporate bonds that have a maturity of less than 1 year. When interest rates were increased by the Federal Reserve, the prices of the bonds in which these funds invested immediately changed.  New short-term bonds that were issued offered higher interest rates because of the hike in general interest rate.  The market price of short-term bonds in which money market funds were already invested also went down with increase in interest rates. But since these bonds have a duration of less than 1 year they can be easily held till maturity. Holding till maturity means getting back the full face value at the time of its maturity, even if the bond price fell before maturity.

 According to data from The Economist, at the time of SVB’s failure money market funds saw inflows of $121 billion in just one week. Total assets under management of money market mutual funds in US has gone up to $ 5.3 trillion in March 2023 from $ 5.1 trillion in March 2022. 

Money market funds also enjoy another advantage in US. They can ask their banks to deposit the money in their accounts with the repo rate facility of US Federal Reserve.  Interest can be earned by depositing money in the repo rate facility. The purpose of having a reverse repo rate facility is to ensure that interest rates do not fall  below a certain level. So when the Federal Reserve increases interest rates, the return given on its reverse repo rate facility also goes up.  Money market mutual funds thus earned higher rates of return this way too. And they passed on these higher returns to their customers. All this while banks were dilly-dallying in increasing their deposit rates.