Overnight rate ETFs have been one of the big success stories of the past 18 months, however, dovish pivots by central banks could soften the products’ duration-free appeal and plunge them back into a period of dormant asset gathering.
According to data from TrackInsight, Europe’s most popular overnight ETF, the $11.4bn Xtrackers EUR Overnight Rate Swap UCITS ETF (XEON), has gathered $5.5bn inflows since the turn of the year, as at 15 August, with investors lured by the current annual 3.97% yield offered by the European interbank rate for one-day loans.
However, after the European Central Bank (ECB) enacted its first cut of the current rate cycle, last week’s flash crash prompted markets to briefly price in 1.25 percentage points of cuts by the Federal Reserve.
A recent note from the BlackRock Investment Institute (BII) said: “Central banks are starting to cut policy rates after the quickest hikes in decades. Cooling inflation should allow the Federal Reserve to cut next month.”
Such a move would not only slash the yield on US dollar overnight rate and short-dated bond ETFs but would perhaps offer other policymakers licence to enact additional rate cuts of their own – reducing the need for investors to huddle at the short end of yield curves.
If history is a reference point, this would spell trouble for overnight rate ETFs, with XEON going from being Europe’s fastest-growing ETF in absolute terms in 2008 to spending more than a decade in the dark amid the zero-interest rate era following the Global Financial Crisis (GFC).
However, the macro and monetary reality is likely very different to the momentary panic response of markets last week.
“We see this as another flip-flop in the market narrative with little evidence backing it,” BII said.
“We see persistent inflation pressures, partly due to ongoing fiscal deficits, keeping interest rates higher on average than pre-pandemic levels.”
It is also clear investors are of a similar mindset, with short-dated government bond and money market ETFs witnessing strong inflows in recent weeks. Additionally, XEON enjoyed one of its strongest months on record, welcoming $1.3bn new assets as at 15 August.
Overnight ETF usage has also undergone an interesting structural evolution in recent years, owing to retail investment platforms turning to the products to power their cash-like offerings.
Ferat Öztürk, EMEA head of digital distribution at DWS, previously told ETF Stream: "Looking into last year and this year so far, a good chunk is coming from digital retail channels – and maybe a little more than half of inflows through Q1 – because they do not have to hop around the 20 different online brokers in Germany to generate interest on cash.”
Prior to the current period of elevated interest rates, XEON was “barely visible” and had “almost no assets” coming from digital channels, Öztürk added.
In sum, XEON and its peers face not only a different macro backdrop versus the post-GFC era but also enjoy a new distribution channel which could mean stickier assets, meaning their success might be more long-haul than overnight.
