Europe’s €500 Billion Money Market Nightmare Is Coming True

Mario Draghi
Mario Draghi, President of the European Central Bank. REUTERS/Kai Pfaffenbach

Money market funds in Europe are fighting to avoid “breaking the buck,” which could trigger huge outflows from the sector.

These funds typically invest in cash-equivalent assets, such as high quality short-term corporate debt or government debt. For investors, the advantage they have over stocks is that they’re a safe place to park cash. You can almost never lose money in a money-market fund.

In return, you’ll get modest but positive returns, with very low risk. Crucially, they strenuously seek to avoid “breaking the buck” — or returning less to investors than they put in.

Unfortunately, with the European Central Bank (ECB) having imposed a negative deposit rate of -0.2% on reserves held at the bank, this task has become harder than ever. Investors who don’t want to lose money are now forced to withdraw it and figuratively hide it under a mattress until the negative interest rate era is over. That could reduce the amount of cash available for companies and governments to borrow (and spend), thus further crippling Europe’s fragile economic recovery.

About €500 billion is invested in European money market funds. (So getting this right is quite important.)

The Telegraph quotes Standard & Poor’s credit director Andrew Paranthoiene as saying that the credit agency is now monitoring these funds closely with an eye to a downgrade that could severely knock investor confidence in the sector.

He said:

Pressure is building for these funds. We’re observing portfolios on a weekly basis. If there is any deviation from our credit metrics, a rating committee would determine if rating action was appropriate. In our view, any loss of capital means that the ‘safety of principal’ has been breached.

So why have we reached this point?

These two charts paint a clear picture of the problem these funds are currently facing in the eurozone.

The yield curve is near zero for short-term debt:

ECB yield curve
Over the last few months the European AAA yield curve has been flattening. ECB

The highlighted area shows that yields on top rated short-dated bonds that money market funds invest in are being squeezed.

Over the past month this squeeze has become even more extreme, it’s gone negative:

ECB yield curve

The squeeze has forced money market funds into investing in
longer-dated assets to secure some yield. But this strategy poses its own problems. Longer-term bonds tend to fluctuate more in value than shorter-term bonds, because interest rates in 10 years time could easily be higher than rates being offered now, which would make them money-losers in the future. That makes it even more difficult for these funds to keep their net asset value steady and avoid “breaking the buck.”

… And that makes the idea of billions being hidden in mattresses ever-more likely.