By Natsuko Waki
LONDON, Oct 4 (Reuters) - Fears of a U.S. default are creeping up in financial markets, with stress in short-term funding markets and bets on prolonged money printing by the Federal Reserve giving money market funds a fresh headache.
Hemorrhaging from money market funds has intensified this year as investors have switched from cash investments that give low or even negative return into instruments that benefit from a recovering economy, such as equities.
Expectations that interest rates will stay low for longer as a result of the latest jitters may reinforce the decline of money market funds, which offer an important source of short-term funds for banks, companies and investors.
The U.S. government shutdown has already dragged on longer than anticipated. Now investors are starting to think the unthinkable - that lawmakers fail to strike a deal to raise the $16.7 trillion borrowing limit by the October 17 deadline and default on U.S. government debt.
"What's going on in the U.S. is a concern for the credit market, because they may have to issue more short-term bills to raise 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 in 2011, selling short-dated Treasuries and buying long-dated debt in 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 monetary policy, it means low rates for longer. It's not good for low risk or zero risk assets like money market funds."
According to Thomson Reuters Lipper, dollar and euro denominated 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 funds have exceeded 200 billion euros since 2008, according to Fitch and Lipper estimates.
Jitters are most evident in the short-end of the credit markets. The yield on one-month Treasury bill shot up to 0.172 percent on Thursday, its highest since November, from around 0.02 percent a week ago.
The cost of insuring U.S. debt against default rose to 58 basis 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 and expectations have risen that the Fed will keep buying bonds for longer.
Reflecting excess cash in the system, the cost of borrowing dollars 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 cash in portfolios," said Mouhammed Choukeir, chief investment officer at Kleinwort Benson.
"At times you need to hold cash to protect against the downside. Currently holding is painful especially over a long period of time because it's being eroded in terms of purchasing power."
Money market funds are in the firing line as they invest heavily in U.S. Treasuries and short-term bills, and increasingly so as a result of a new rule put in place after the crisis.
Regulators are pushing these funds to hold safer and more liquid instruments after U.S. money manager Reserve Primary Fund, which invested in commercial paper issued by Lehman Brothers, "broke the buck" in Sept 2008, with its net asset value per share falling below $1.
Under the rule, known as 2a-7, the average dollar-weighted portfolio maturity of investments held in a money market fund cannot exceed 60 days.
No more than 5 percent of assets can be invested in securities that are in top two ratings categories.
In an event of default, they may have to get rid of defaulted securities. But it does not necessarily mean panic selling because the rule states the disposal should take place "as soon as practicable", unless the board of directors finds that a disposal would not be in the best interests of the fund.
U.S. asset manager Federated Investors estimates that it would take a spike in rates on short-term securities of approximately 300 basis points before the net asset value of a money market fund with a 60-day average maturity would be in danger of breaking a buck.
So it's a case of slow suffering rather than an immediate crisis, because it would take a while for cash rates to go up.
"We still see some light at the end of the tunnel - the bias is for short rates to begin to move up and for the cash curve to steepen. It's just that the moves won't come as early as we were thinking a month ago," Deborah Cunningham, chief investment officer of global money markets at Federated, said in a note.