* Money funds' euro zone exposure rises sharply in H2 2012
* Higher rates, better economic data pull money back in
* ECB's safety nets "inspire confidence"
* Situation still fragile, crisis could flare again
By Marius Zaharia
LONDON, Feb 13 U.S. money market funds are
slowly returning to the euro zone, lured by a gradual rise in
interest rates as the lenders grow more confident the bloc can
contain its debt crisis.
For now, funds remain selective with the banks they lend to,
preferring the security of those in the top-rated economies in
case the three-year-old crisis flares up again.
Their renewed interest in the region is, nevertheless,
re-opening an important funding source for banks, whose lending
on to businesses is crucial to accelerating a fragile economic
Encouraged by the safety net of the European Central Bank's
new, though so far unused, bond-buying programme and slightly
better than expected business sentiment, euro zone banks have
begun to wean themselves off central bank support.
They have so far paid back nearly a third of the first
emergency three-year loans (LTROs) taken from the ECB in
November 2011, creating expectations the excess cash in the euro
zone banking system may shrink faster than initially thought.
This led to a rise in money market rates and an opportunity
for U.S. funds to step back in, after almost turning off the tap
on the euro zone in July, when the ECB cut its deposit facility
rate to zero, pushing market rates into negative territory.
"We definitely think things are improving from an economic
perspective and that's probably what's driving rates higher,"
said Deborah Cunningham, chief investment officer at Federated
Investors, a firm managing $285 billion in money funds.
"With the payback of LTROs by the various banks, they're
going to need some direct financing coming from the market
rather than from the ECB...That's going to increase the supply
that we will have to choose from over there," she said,
referring to euro zone banks' borrowing requirements.
Borrowing from a fund is cheaper than from the ECB.
With the past six months' rise in euro zone market interest
rates, she was planning to "put more money at work" in both
euros and dollars for longer, having previously restricted loan
lengths to no more than a month.
Money market traders said they had seen increased lending in
maturities of three and six months and even noticed some
one-year trades in January, a rare sight during the crisis.
Six-month Eonia rates, which reflect the average
expected overnight rates during the period and often move in
tandem with rates on similar-dated commercial paper issued by
the region's strongest banks, last traded at about 0.12 percent,
compared with a low of minus 0.03 percent at the end of July.
One-year Eonia rates are about 0.18 bps, while
one-year benchmark euro Libor rates are below 0.50 percent
. Banks repaying their long-term ECB loans after one
year are charged just over 0.75 percent interest.
Back in July, money market funds, which use investors' money
to lend to banks, companies or governments for short periods --
typically less than two years -- struggled to offer any returns.
At negative rates, a lender is effectively penalised.
JPMorgan Chase & Co, BlackRock Inc and
Goldman Sachs Group Inc, restricted investor access to
their European money funds, immediately after the ECB's deposit
rate cut. JPMorgan said it has since lifted most of the
restrictions. The other two firms still have them in place.
A survey by Fitch Ratings published in January showed,
without providing detailed figures, U.S. prime money market
funds' exposure to the euro zone at the end of 2012 was more
than 70 percent higher than six months earlier, due to "ECB
actions and a general softening in euro zone market volatility".
Allocations to the region probably rose further in January.
Wells Capital Management, which manages $136 billion in money
market assets, has increased exposure since the start of 2013.
"Near-term there has been ... sufficient confidence inspired
to investors that things are going well," said David Sylvester,
the company's head of money funds.
But Fitch said euro zone exposure was still more than 60
percent below end-May 2011 allocations, when three- and
six-month rates were above 1 percent, and was unlikely to regain
those levels any time soon.
Later in 2011, benchmark borrowing costs in Italy and Spain
reached unsustainable levels, raising doubts the currency union
would survive. The subsequent flight of U.S. money funds from
Europe raised fears about the health of the euro banking system.
The three-month euro/dollar cross currency basis swap
, which measures the cost of swapping euro
funding for dollars, hit its most expensive levels since the
collapse of Lehman Brothers at minus 167.5 basis points in
November 2011. The cost has since tumbled to minus 23 bps.
Concerns about the debt crisis, even if subsiding, remain
and keep many fund managers cautious about the euro zone.
"Rates have been slightly better, but we would like to see a
longer period of improvement," said one money market funds
provider, who asked not to be named. "It does look like rates
are bottoming out, but the situation remains fragile and it
could just as easily flip back."
The major worry is that the improvement in euro zone data is
mainly driven by the stronger economies, while others still have
major structural weaknesses.
"We just feel there's more writedowns to occur there," said
Cunningham of Federated, which does not invest in lower-rated
euro zone countries.