July 13, 2012 / 4:42 PM / 7 years ago

MONEY MARKETS-Fed unlikely to follow ECB rate cut - UBS

* US excess reserve rate cut might disrupt money market funds

* European money markets tackle uncharted waters

* Search for yield as more rates turn negative

By Chris Reese and Kirsten Donovan

NEW YORK/LONDON, July 13 (Reuters) - The U.S. Federal Reserve is unlikely to follow the European Central Bank’s move to a zero percent deposit rate due in part to fears of disruptions to money market funds, according to UBS strategist Chris Ahrens.

The ECB last week cut its main refinancing rate to 0.75 percent and its overnight deposit rate - which is paid to banks that park cash in the central bank’s deposit account - to zero.

U.S. money market fund managers breathed a sigh of relief earlier this week after minutes from the Fed’s June policy meeting showed no indications the central bank was considering cutting the interest rate it pays on excess reserves to banks.

Many fund managers believe any cut in the rate, which currently stands at 0.25 percent, would cause disruptions in funding markets, especially money market funds.

“We agree with our economists that the Fed is unlikely to reduce interest on excess reserves (IOR),” Ahrens said. “The Fed discussed this alternative in detail at the September 2011 meeting but was reluctant to exercise this option. Moreover, June 2012 Federal Open Market Committee (FOMC) meetings did not mention IOR, and recent speeches have not included it.”

“The Fed’s reluctance to cut the rate stems primarily from ‘concerns that reducing the IOR rate risked costly disruptions to money markets and to the intermediation of credit’,” Ahrens said, quoting from FOMC minutes from Sept. 20-21, 2011.

“Our read is that the central bank worries that reducing IOR would elicit meager gains at the potential cost of eroding the architecture of the financing markets and fracturing the link between the policy rate and various funding rates,” Ahrens said.

Meanwhile, implementation of the ECB’s zero percent deposit rate this week has pushed money markets into uncharted territory, forcing many to accept negative returns while Seemingly doing little to spur bank lending.

T-bill yields and repo rates are below zero for the euro zone’s more-trusted “core” countries and they are falling even for Spain and Italy - despite the euro zone debt crisis appearing no closer to being resolved. Bank-to-bank Euribor lending rates are in free fall.

The changes came into force with the start of the new maintenance period on Wednesday but JPMorgan Chase & Co, BlackRock Inc, which is the world’s largest money manager, and Goldman Sachs Group Inc had already restricted investor access to European money market funds .

Commerzbank strategist Christoph Rieger described the move to zero or negative rates as “a small step for the ECB but a giant leap for money markets”.

“While some investors will likely still be willing to pay a price for safe investments, others will either be keen to exit the euro or should grudgingly revise their credit and duration limits... in an attempt to preserve the nominal value of their investments,” he said in a note.

While banks are now not making any cash from the ECB, analysts are skeptical that they will increase lending to the wider economy in response. But there is some suggestion that banks may be seeking even modest returns by buying more sovereign debt - which could potentially ease euro zone policymakers’ headaches somewhat on that front.

Tradeweb quotes one-month T-bill yields for Germany, France, Holland and Belgium at close to zero or below, while Spanish yields have fallen to 0.90 percent from around 1.5 percent ahead of the ECB meeting.

Similarly, secured lending rates in the repo market - where banks commonly use government bonds as collateral to raise funding - have collapsed.

General collateral repo rates, which are paid to borrow funds against a basket of government bonds, are negative for the core countries and falling in Spain and particularly Italy. An Italian bond auction on Friday saw good demand despite a ratings cut earlier in the day.

“Italy appears to have been a major beneficiary of the search for yield,” said ICAP economist Don Smith, referring to the repo market.

“Bid interest in this market has surged in the last two days and repo rates have correspondingly dropped...(jibing) with the previous rising trend set against a backdrop of elevated lending concerns.”

With no incentive for banks to deposit money at the ECB overnight, cash is being hoarded in institutions’ current accounts, central bank data showed this week.

While it is impossible to tell how much money may be being used to buy shorter-dated government bonds from the figures, there is only anecdotal evidence from market players.

However, Smith says reports from Brokertec’s euro government bond platform suggest a “scramble” for short-dated Austrian, Belgian, French and Dutch debt.

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