Early Signs of Money Market Stress and Implications for Short-Term Strategies

The Federal Reserve’s “wait-and-see” approach to interest rates has created a precarious balancing act for investors. With the federal funds rate held steady at 4.25%–4.5% since March 2025 and uncertainty looming over trade policies and inflation, liquidity risks in money markets are beginning to surface. These early signals demand a reevaluation of short-term strategies, particularly in cash equivalents like commercial paper, Treasury repos, and money market funds.

Repo Market Dynamics: A Fragile Floor

The Fed’s reliance on the Standing Repo Facility (SRF) to anchor short-term rates has been tested. While repo rates like the Secured Overnight Financing Rate (SOFR) remain stable, occasional spikes above the SRF’s minimum bid rate signal underlying tension. In December 2024, tri-party repo transactions briefly breached the SRF’s floor, a warning of liquidity strains as the Fed’s balance sheet shrinks.

The Fed’s refinements to the SRF—including morning-settling auctions—aim to bolster its effectiveness, but the hurdle rates remain a vulnerability. Investors in Treasury repos must now prioritize institutions with direct SRF access, as smaller players may face margin squeezes during stress periods.

Commercial Paper Spreads: Quality Over Yield

Commercial paper (CP) markets reveal a widening divide between top-tier issuers and riskier borrowers. As of May 2025, AA-rated nonfinancial CP yields averaged 4.3%–4.4%, down slightly from last year. However, A2/P2-rated paper now trades at 4.5%–4.7%, a spread of 0.2–0.3% over AA issuers—a stark reminder of credit differentiation in a cautious Fed environment.

Investors should favor AA-rated issuers, even if it means sacrificing a fraction of yield. The recent spike in TIPS bid-ask spreads (up 30 bps in April 2025) underscores how liquidity can evaporate quickly.

Liquidity Metrics: The Hidden Cracks

Despite the Fed’s assurances of “ample reserves,” Treasury market liquidity is deteriorating. The 10-year on-the-run Treasury’s market depth fell to one-quarter of 2024 levels in April, though it has partially recovered. Meanwhile, the OFR Financial Stress Index (OFR FSI) has climbed to its highest point since early 2020, reflecting cross-market anxiety.

The lesson? Cash equivalents are no longer “risk-free.” Investors must diversify beyond Treasuries, considering short-term corporate bonds with strong balance sheets or high-quality money market funds that avoid volatile sectors like commercial paper.

Tactical Shifts for Short-Term Portfolios

1. Shorten Duration, Prioritize Liquidity: Focus on Treasury bills and ultra-short bond funds with durations under six months.
2. Quality First: Avoid A/P-rated commercial paper; allocate to AA issuers or government-backed securities.
3. Diversify Counterparties: Use institutions with SRF access to mitigate repo market risks.
4. Monitor Fed Signals: Track the SRF’s utilization rate and SOFR fluctuations—their divergence could signal a liquidity crisis.

Conclusion: Act Now Before the Fed’s Next Move

The Fed’s reluctance to cut rates before September 2025 leaves money markets in limbo. Early stress indicators suggest that the “cash is king” mantra no longer applies—it’s time to be a selective, vigilant king.

Investors who pivot to high-quality, short-duration instruments now will be positioned to capitalize on opportunities when the Fed finally shifts course. The risks are real, but so are the rewards for those who adapt.

The writing is on the wall: liquidity is fragile, and complacency is costly. Adjust your strategy—or risk being left behind when the next storm hits.