By Natsuko Waki
LONDON Oct 4 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
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
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
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.