Saturday, July 7, 2012

Draghi's zero deposit rate policy put an end to euro money market funds

There has been some confusion as to why the biggest US mutual fund operators are closing euro denominated money market funds to additional investments. The decline in euro cash fund products is not a new trend (see this post for some background) since such products have been unprofitable for quite some time. The managers have been subsidizing these funds in order to service their clients in hopes of recouping losses from more profitable programs. But Draghi's recent and somewhat surprising move to set the deposit rate to zero had finally put an end to these offerings.

Here is how these funds were kept operational. As money funds shifted away from commercial paper and into secured lending (due to heightened credit risk aversion), they were only able to scrape 12-20bp annualized returns throughout much of this year. Not enough to cover expenses, but it was something. Of course most investors in the funds were receiving zero returns for the privilege of holding euros with say a JPMorgan money fund.

The funds would lend (for 1-3 months) to Eurozone banks who had some excess collateral sitting around. These banks would post collateral, eliminating credit risk for the money funds. In turn banks would deposit this cash with the ECB and make a spread (about 13bp in the example below). Easy money if you have a few Bunds sitting around.

But once the deposit rate at the ECB was set to zero, the party was over. Banks could no longer make money this way and term repo rates collapsed to zero (see chart below). In fact some banks just stopped doing this altogether (putting a damper on the overall term repo market - see Kostas Kalevras updated post on the topic).

1m eurepo rate

Without the ability to invest via term repo, money market funds (as well as other cash holders) moved funds into the only thing they felt was safe in the euro world: German government paper. That pushed German notes with maturities of two years and under deep into negative yield territory. Such conditions simply make it impossible to operate a euro denominated money market fund, causing these firms to pull such products off the market (see the video below for more background).
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