In an increasingly varied macro-economic environment, cash management is as important as ever. Many corporate treasurers use money market funds (MMFs, also known as liquidity funds) as a tool for managing their cash. MMFs aim to preserve capital, provide on-demand liquidity and deliver a competitive yield.
But what can we expect from MMFs in 2025?
While central bank rates – and hence liquidity fund yields – may not match the highs of 2024, we still expect levels of cash income to be healthy in 2025 and certainly well above the lows of the 2010s. 'Step-out' strategies, such as 'standard' MMFs and ultra-short bond funds, could be useful tools this year to help investors achieve higher overall blended yields while maintaining good levels of liquidity.
A rigorous and repeatable credit process is critical at all times
The core view across the major credit rating agencies is that conditions are neutral for banks, which indicates that they do not expect material credit deterioration over the next one to two years. This should help MMFs achieve their objective of preserving capital, particularly given their ability to diversify risk across counterparties.
This picture is reflected in credit spreads, which are tight. Default rates are widely forecast to remain low in 2025, although it is worthwhile pausing to reflect on the incidence of bank failures over the years. The key point is: banks do fail.
The moral of this story is simple: while credit conditions may appear benign, issues can still occur. A rigorous and repeatable credit process is critical at all times.
Liquidity fund managers always seek to manage liquidity levels prudently, so they can deliver on their objective of providing timely liquidity. Even with flows being broadly positive during 2024, liquidity funds generally maintained high levels of liquidity, well above regulatory minima.
But despite these levels of prudence, US authorities increased minimum liquidity requirements for US funds and the UK proposed increases, too. Whether Europe follows suit remains to be seen.
It’s all going to be about the shape of the short-term yield curve
Most major central banks are in a rate-cutting mode. The key challenge for liquidity fund portfolio managers will be in predicting the timing and magnitude of future rate changes and hence the relative value of securities with different maturities. In other words, it’s all going to be about the shape of the short-term yield curve.
Looking at 2025, market participants have adjusted their expectations. Median forecasts from economists do, however, still point to cuts ahead, with inflation developments representing a key factor in the outlook.
The more fundamental point is that there is no current indication of rates falling back to the ultra-low levels of the 2010s. With inflation falling, and below central bank base rates, the yields on liquidity funds should be positive in real terms.
There are options for those investors seeking to generate higher yields in a declining rate environment.
For investors unwilling to step outside the regulated liquidity fund perimeter, 'standard' MMFs can be an option. These operate with longer weighted average maturities than 'short-term' MMFs, and can therefore generate potentially higher yields, especially as rates fall.
Short-term bond funds come in many shapes and sizes. Many will have material allocations to short-dated corporate bonds, potentially rated in the 'BBB' category. We believe there are assets with more stable profiles available that can deliver incrementally higher yields.
We think it highly likely the European Commission (EC) will put forward proposals to change the MMF regulation in 2025. There are two key topics we expect to be raised.
First, 'delinking' or a removal of the link between weekly liquid assets and the potential imposition of liquidity fees and gates. The EC has already indicated it is minded to remove this link as it proved to have unintended consequences. That’s a positive.
Second, 'increased liquidity requirements'. The US Securities and Exchange Commission mandated higher liquidity levels and the FCA in the UK has called for it. While the EC has stated that current levels are adequate, we see pressure from multiple quarters to demand more. This should make liquidity funds safer, but then again, the evidence shows that even in severe scenarios current liquidity levels have proven adequate to date. More fundamentally, it could reduce the yield liquidity funds can generate.
Alastair Sewell is liquidity investment director at Aviva Investors
Disclaimer: the views and opinions expressed in this article are those of the author and not necessarily those of the ACT. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature.