By Natsuko Waki
LONDON, Oct 4 (Reuters) - Fears of a U.S. default arecreeping up in financial markets, with stress in short-termfunding markets and bets on prolonged money printing by theFederal Reserve giving money market funds a fresh headache.
Hemorrhaging from money market funds has intensified thisyear as investors have switched from cash investments that givelow or even negative return into instruments that benefit from arecovering economy, such as equities.
Expectations that interest rates will stay low for longer asa result of the latest jitters may reinforce the decline ofmoney market funds, which offer an important source ofshort-term funds for banks, companies and investors.
The U.S. government shutdown has already dragged on longerthan anticipated. Now investors are starting to think theunthinkable - that lawmakers fail to strike a deal to raise the$16.7 trillion borrowing limit by the October 17 deadline anddefault on U.S. government debt.
"What's going on in the U.S. is a concern for the creditmarket, because they may have to issue more short-term bills toraise funds. What you get is a flattening of the yield curve.It's an unintended Operation re-Twist," said Mike Howell,managing director of CrossBorder Capital.
The Fed launched the so-called Operation Twist programme in2011, selling short-dated Treasuries and buying long-dated debtin order to hold down long-term interest rates.
"The Fed is clear if you've got a situation where anything,not just a government shutdown, affects the path of monetarypolicy, it means low rates for longer. It's not good for lowrisk or zero risk assets like money market funds."
According to Thomson Reuters Lipper, dollar and eurodenominated money market funds -- a $2.5 trillion industry --has suffered combined outflows of $65 billion so far this year.
Cumulative net outflows from European money market fundshave exceeded 200 billion euros since 2008, according to Fitchand Lipper estimates.
Jitters are most evident in the short-end of the creditmarkets. The yield on one-month Treasury bill shot up to 0.172percent on Thursday, its highest since November, fromaround 0.02 percent a week ago.
The cost of insuring U.S. debt against default rose to 58basis points on Friday, its highest since August 2011.
On the other hand, the 10-year U.S. Treasury yield has been falling as equities have weakened andexpectations have risen that the Fed will keep buying bonds forlonger.
Reflecting excess cash in the system, the cost of borrowingdollars for three-months in the London interbank market (Libor)hit record lows of 0.2428 percent this week.
"Low Libor or cash rates make it very difficult to hold cashin portfolios," said Mouhammed Choukeir, chief investmentofficer at Kleinwort Benson.
"At times you need to hold cash to protect against thedownside. Currently holding is painful especially over a longperiod of time because it's being eroded in terms of purchasingpower."
Money market funds are in the firing line as they investheavily in U.S. Treasuries and short-term bills, andincreasingly so as a result of a new rule put in place after thecrisis.
Regulators are pushing these funds to hold safer and moreliquid instruments after U.S. money manager Reserve PrimaryFund, which invested in commercial paper issued by LehmanBrothers, "broke the buck" in Sept 2008, with its net assetvalue per share falling below $1.
Under the rule, known as 2a-7, the average dollar-weightedportfolio maturity of investments held in a money market fundcannot exceed 60 days.
No more than 5 percent of assets can be invested insecurities that are in top two ratings categories.
In an event of default, they may have to get rid ofdefaulted securities. But it does not necessarily mean panicselling because the rule states the disposal should take place"as soon as practicable", unless the board of directors findsthat a disposal would not be in the best interests of the fund.
U.S. asset manager Federated Investors estimates that itwould take a spike in rates on short-term securities ofapproximately 300 basis points before the net asset value of amoney market fund with a 60-day average maturity would be indanger of breaking a buck.
So it's a case of slow suffering rather than an immediatecrisis, because it would take a while for cash rates to go up.
"We still see some light at the end of the tunnel - the biasis for short rates to begin to move up and for the cash curve tosteepen. It's just that the moves won't come as early as we werethinking a month ago," Deborah Cunningham, chief investmentofficer of global money markets at Federated, said in a note.
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