Massive inflows in recent years

U.S. money market funds (MMFs) have experienced massive inflows since the end of 2022. At just above USD 6 trillion, they currently stand at an all-time high.^[1] In our view this isn’t about to change: big outflows are unlikely in the shorter-term. But what has driven the enormous interest in this short-term investment opportunity is an important question. As is what would need to happen for capital to be withdrawn equally suddenly. These investments are, by their very nature, short term, and (overly) rapid outflows, reallocating the funds to other asset classes, can certainly happen, making markets volatile.

Money market funds have also seen inflows in the Eurozone recently, but the volumes appear relatively small. The chief reason, in our view, is that European investors place much less emphasis on the security aspect of funds than their U.S. counterparts. Given the much lower importance of money market funds in Europe and the Eurozone, we are only looking at the U.S. instruments in this publication.

1 / U.S. money market fund volume reaches record high

1.1   Money market funds as a short-term parking option for capital

Money market funds are generally defined as investment funds that invest their assets in liquid money market securities. They are assumed to offer a high level of security for investors. Besides that, their most important feature is their short-term nature. Money market securities include certificates of deposit, time deposits, bank or corporate notes and bonds, and shares in other money market funds. These securities usually have a maturity of twelve months or less.

Money market funds are generally used by a wide variety of investor groups to park money before it is allocated to other, typically longer-term investments. Banks, governments, and corporations have long been among the largest investors in MMFs and currently account for about 60% of the total. In recent years, however, it has become increasingly clear that retail investors are also making much greater use of this vehicle. Their holdings have increased by around 75% over the past 24 months. As one of the main characteristics of MMF investments is their short-term investment horizon, the securities held in the fund are highly liquid and permit quick portfolio rebalancing.

1.2 Market stress as a potential trigger for inflows into MMFs

In principle, MMFs do not differ from other investment funds in the way they work, and this is also an important reason why retail investors are increasingly using them to park their capital. When investor nervousness and volatility are high in the markets, money market funds tend to become more popular. Funds that invest exclusively in U.S. government or government-related securities, which are generally seen as safe investments, are by far the largest group of MMFs, because of the perceived safety of these securities.

Looking at flows into U.S. money market funds over the past decade and a half, it is easy to see that periods of financial market stress have often led to a noticeable increase in volumes. The underlying source of the nervousness, whether geopolitical or from market stresses, did not seem to matter. The overall level of stress in U.S. markets can be seen in the Financial Stress Index produced by the Federal Reserve Bank of St. Louis. As defined by the bank, the index “measures the degree of financial stress in the markets and is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. Each of these variables captures some aspect of financial stress. Accordingly, as the level of financial stress in the economy changes, the data series are likely to move together.^[2]

Over the past decade, in times of market uncertainty, money market flows tended to be higher (January 2007 – May 2024)

^{Sources: Bloomberg Finance L.P., Federal Reserve St. Louis, DWS Investment GmbH as of 5/10/24}

The development of the index in early 2020 was particularly striking. The global outbreak of Covid-19 sent shockwaves through the financial markets and prompted many investors to allocate capital to the perceived safety of money market funds. The increase in weekly inflows into these funds in early 2023 was also striking, as concerns about the stability of U.S. regional banks drove volatility sharply higher. This was not just a general flight to safety. Large amounts of deposits held at the troubled regional banks and other smaller regional banks were moved as investors feared for the safety of these funds. Not only did capital shift towards money market funds; deposits in larger U.S. banks, which were perceived to be safer, were also very popular.

1.3 Money market funds as a "safe haven" with attractive interest rates

The supposed relative attractiveness of investments in money market funds compared to the available alternatives is an important factor influencing inflows into this asset class, but just one of many. And the degree of attractiveness varies considerably in market phases, depending heavily on the monetary policy of the U.S. Federal Reserve.

After the 2008 financial crisis central banks around the world kept interest rates at rock bottom, creating a capital market environment that was extraordinary in many respects. Yields in international bond markets fell to unprecedented lows and even negative territory in some sub-markets and segments.

In March 2022 the Federal Reserve began to raise interest rates in an attempt to curb runaway inflation. About two months later the U.S. yield curve inverted, with shorter maturities yielding more than longer maturities. The inversion of the Treasury curve continues to this day. Against this backdrop it has been more attractive to invest in shorter maturities, offering higher yields. As a result, even before the outbreak of the regional banking crisis in the U.S. in March 2023, the volume of money market funds had risen in line with money market yields, although the increase was still quite modest. From the start of the rate hike cycle in March 2022 until just before the start of the banking tensions, money market fund assets increased by around USD 330 billion, or around USD 28 billion per month. In our view, this seems to be a good representation of typical investor behavior during a Fed tightening cycle.

Money market fund volumes tended to have a response lag to Federal Reserve interest rate cuts (January 1990 – May 2024)

^{Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 5/10/24}

Research by the Federal Reserve Bank of New York has shown that, in the past, a one percentage point increase in the effective federal funds rate led to a 6-percentage point increase in fund assets over a two-year period because of the close correlation with money market fund yields.^[3]This shows that money flows are generally quite slow to react to changes in yields. In our view, however, it is also important to note that the relationship often does not hold during periods of financial stress. A pertinent example is the Covid-19 outbreak in 2020, when a massive increase in money market fund inflows coincided with a sharp decline in policy rates.

Another factor in this context is the sometimes stronger, sometimes less pronounced competition between money market funds and investors' deposits at banks. Until the outbreak of Covid-19, bank deposits showed a rather dull momentum of their own, with growth rates that were comparatively constant for well over a decade. It was only the extreme reduction in key interest rates in the wake of the pandemic that provoked a marked interest in not only money market funds but also bank deposits, with the zero-interest rate policy then making deposits more attractive. This lasted almost until the problems of the U.S. regional banks became apparent. This crisis, which, at least for a brief moment, was seen as a threat to the entire banking system, proved something of a spark for money market funds. Their volume catapulted to the levels we see today without any major setbacks.

Money market funds and bank deposits compete only occasionally (January 2005 – May 2024)

^{Sources: Bloomberg Finance L.P., DWS Investment GmbH as of 5/10/24}

To summarize, relative attractiveness of course influences inflows into money market funds, but the relationships are complex.  Which influencing factor dominates the inflows into money market funds depends very much on the broad market constellation.