It's 'Training Day', And $800 Billion Is At Stake

| About: SPDR S&P (SPY)

Summary

"Since you can't keep your mouth shut long enough for me to read my paper tell me a story.".

More than three quarters of a trillion dollars is moving.

Do you know where and why?

Two eggs are cracked, the grill sizzles. Patrons sit on diner bar stools hunched over, quietly eating their breakfast. The voice of a Spanish-speaking female radio news reporter drifts about in the background as the camera pans right. Denzel Washington is seated in a booth, his back to us.

Ethan Hawke walks in the front door. He's visibly anxious. He taps the seat opposite Washington as if to ask permission to sit down. A waitress walks over, but before she can put the menu down, Hawke tells her "no thank you, ma'am."

Washington, without looking up from the paper he's reading, gestures at the waitress. "No, get some chow in you before we go to the office, my dollar." Hawke stammers. Washington doesn't miss a beat. "Ok, fine don't."

A few seconds pass. Hawke can't stand the tension. "It's nice here," is all he can manage as a second attempt to make a first impression. For the first time we see Washington's eyes. He looks up: "May I read my paper?" At a loss, Hawke says he'll get something to eat after all. In no uncertain terms, Washington tells him that ship has sailed.

Hawke tries one more time to engage Washington, who then looks up and laughs, his eyes conveying a sense of the evil we'll see in him as the film progresses. Here's the classic exchange that follows:

Washington: "Tell me a story, Hoyt."

Hawke: "What, like my story?"

Washington: "No, a story, not your story, a story. Since you can't keep your mouth shut long enough for me to read my paper tell me a story."

Hawke: "I don't think I know any stories."

Washington: "You don't know any stories? Alright, I'll tell you a story. This is a newspaper right? It's 90% bullsh*t. But it's entertaining. That's why I read it. Cause it entertains me. You won't let me read it. So you entertain me with your bullsh*t. Tell me a story."

That's from Training Day, the classic drama about police corruption in LA. Denzel Washington won an Oscar for his role as Alonzo Harris, a ruthless detective who drags an unwitting new recruit into a scheme to extort a drug dealer for the money Harris needs to pay off the Russian mob.

For the last oh, I don't know, 13 or so hours I've been trying to figure out the best way to frame something a friend of mine told me a few months ago. Here's what she said (this is paraphrased and you won't know the context, but that doesn't matter):

It says something important about how we consume the news; who delivers it and how it's delivered.

That really resonated with me. At the time I was trying to make sense of a particular story I read - trying to figure out why and if it was worth printing.

On Friday night I was again reminded of what she said as I was straining to read another New Yorker article about Donald Trump in an unnecessarily dark bar after an unnecessary second carafe of hot sake and an even more unnecessary shot of Wild Turkey 101 (blame the Eastern European bartender who, incidentally, says she is now going to apply to "every Wall Street bank just for the hell of it"). Here's the quote from The New Yorker (emphasis mine):

Where is all this anger coming from? It's viral, and Trump is Typhoid Mary. Intellectually and emotionally weakened by years of steadily degraded public discourse, we are now two separate ideological countries, LeftLand and RightLand, speaking different languages, the lines between us down. Not only do our two subcountries reason differently; they draw upon non-intersecting data sets and access entirely different mythological systems. You and I approach a castle. One of us has watched only "Monty Python and the Holy Grail," the other only "Game of Thrones." What is the meaning, to the collective "we," of yon castle? We have no common basis from which to discuss it. You, the other knight, strike me as bafflingly ignorant, a little unmoored. In the old days, a liberal and a conservative (a "dove" and a "hawk," say) got their data from one of three nightly news programs, a local paper, and a handful of national magazines, and were thus starting with the same basic facts (even if those facts were questionable, limited, or erroneous). Now each of us constructs a custom informational universe, wittingly (we choose to go to the sources that uphold our existing beliefs and thus flatter us) or unwittingly (our app algorithms do the driving for us). The data we get this way, pre-imprinted with spin and mythos, are intensely one-dimensional.

Let me tell you something that may shock you. As an investor, the best "journalism" you can read without access to Bloomberg's newsfeed, are those quick take Reuters pieces where they do something like 150 words at most on a breaking story. Do you know why those are good for you? Because they didn't have time to inject any opinion or spin. It's just "here's what just happened." It's up to you to analyze it.

The New Yorker is right. We're all walking examples of confirmation bias and we double down on it like I doubled down on the hot sake (which for God's sake was way too hot on the second batch making me rethink the merits of that McDonald's coffee case).

What I try to do is find information that for one reason or another is largely free from the "pre-imprinted spin and mythos." That's why some of what I write seems esoteric to some readers. Everyone wants to be told a story and preferably one that's consistent with what they were thinking before they read it. I have no interest in that except for the fact that like Denzel in the movie, the stories "entertain me." I look for analysis that is meaningful for markets (preferably at the structural level) and is, for whatever reason, largely immune to the injection of bias and spin.

That's why I've spent so much time discussing money market reform. That sounds like the most painfully boring topic in all of finance, but as I've explained previously (see here for instance), it's extremely important. Prime money market funds invest in commercial paper. Commercial paper is a critical source of funding for corporate America. Here's how PIMCO's Anthony Crescenzi (formerly chief bond market strategist at Miller Tabak) explained the situation in September of 2008 when the market was getting squeezed (emphasis mine):

The commercial paper market is where companies go to raise money for such short-term uses as inventory investment, funding credit cards, and for payrolls. Commercial paper matures within 270 days, but most matures within 30 to 45 days, making it vital for companies to tap the market for money quite often. Commercial paper is sold for "transactions purposes" only, SEC rules state, which for example includes inventory investment. Without commercial paper issuance, $1.7 trillion of short-term credit would dry up, imperiling the ability of companies to produce goods and services, and resulting in big job losses from both a direct and indirect hit.

The exodus from prime funds ahead of new regulations that kick in in October means that hundreds of billions in funds that were previously available for companies to tap have disappeared and likely aren't coming back.

This is a perfect example of the type of information and analysis that I love - it's extremely important, but almost impossible to spin because it's basically just all numbers.

Fortunately for me - and you if you want to understand a critical component of the market's scaffolding instead of searching for "stories" that confirm to your political and financial convictions - BofAML is out with an excellent in-depth look at what I've been talking about for weeks. Let's look at a few excerpts, shall we?

First of all, here's a snapshot of the market broken out by government funds and prime funds:

Click to enlarge

(Table: BofAML, Investment Company Institute)

So between CDs and commercial paper, prime funds are providing something like $600 billion in short-term funding. Here's a rundown of the upcoming changes:

Click to enlarge

(Table: BofAML)

Now if you're thinking two steps ahead (and should always be doing that in anything you do) you can anticipate how this could trigger a self-feeding loop. You're a prime MMF manager. You have no idea how much money is going to leave your fund between now and October, when the new rules kick in. That creates a maturity mismatch problem. That is, you can't buy any three-month paper because that would tie up funds past the date on which the new regulations kick in. But if you can't take any duration risk, guess what happens to yields? That's right, they fall. And the lower yields on your fund go, the less attractive your fund looks to investors versus a government MMF. That means even more outflows. And around we go. Here's BofAML:

As a result of these regulatory changes, money fund investors are expected to shift a large amount of their holdings out of prime and municipal funds and into government funds. However, these money fund investors have provided limited clarity on how much they will move which creates a large amount of uncertainty for prime fund managers. The uncertainty around potential outflows has resulted in prime fund managers staying very liquid, shortening their WAMs and WALs, and thus reducing the overall yield they are able to offer investors (Chart 12). Indeed, the spread between institutional prime and government money fund yields reached a local peak of 17 basis points in early May and has since declined 5 basis points (Chart 13). We expect a continued decline in the yield advantage of prime funds as WAMs and WALs further shorten, which should reduce the attractiveness of investors to remain in these products and drive larger outflows.

Click to enlarge

Look where prime funds are piling up their maturities:

(Chart: BofAML)

So what does this mean for issuers? Well, here's what BofAML's short duration clients said when asked:

(Chart: BofAML)

See why this is so important? This literally affects the cost of doing business in a material way. For their part, BofAML expects $800 billion will flee prime funds before it's all said and done. For anyone who still doesn't think this is particularly important or notable, just bear in mind that $800 billion doesn't just move around with no consequences.

Remember, this is the market that panicked Treasury officials in Lehman's wake.

So what could go wrong? Well, outflows could exceed estimates. As mentioned above, falling yields will only fan the flames. Note also that after the reforms take effect, funds will be able to gate investors if "weekly liquid assets" fall below 30% of a fund's total holdings. There's nothing like a good old redemption suspension to panic the market (NYSEARCA:SPY).

But who cares, right? Because there's dividend portfolios to talk about. And Apple's got a new phone coming. And Elon Musk is going to build a Hyperloop to Mars. And Barron's is out with a list of "six steady growers with room to rise." And didn't you hear? Obama paid Iran a $400 million ransom for kidnapped sailors. And Trump's on, so be quiet.

All of that is undoubtedly entertaining. But like Denzel, recognize it for what it is: entertainment. Of course I aim to entertain as well. But I prefer to do it in a way that isn't, to quote Denzel, "90% bullsh*t", which means taking complex and seemingly boring subjects like money market reform and explaining them in a way that's accessible and fun.

As my friend said, it's important to think about who delivers news and how it's delivered. I try my best to be an island in a sea of noise.

Now then, "may I read my paper"?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.