ECB rate cut is a credit negative for Euro money market funds, says Moody’s Eberhardt
Michael Eberhardt, vice president and senior analyst at Moody’s, says in the rating agency’s latest weekly outlook that the recent ECB rate cuts are bad news for money market funds.
Last Thursday, the Governing Council of the European Central Bank (ECB) cut the interest rate on its deposit facility by 25 basis points to 0.00%, effective 11 July. The reduction of the ECB’s deposit rate, the interest rate the ECB pays on funds that commercial banks deposit overnight with the central bank, is credit negative for euro-denominated money market funds (MMFs) and their managers for two reasons.
First, it will reduce bank demand for borrowing in the short-term euro money markets, which will further reduce MMFs’ asset supply amid a more than yearlong decline in the availability of eligible assets.8 Second, the deposit rate cut will drive yields on short-term money market paper lower, in some cases to negative levels.
With yields on European prime and government MMFs already at historical lows, a rebasing of money market rates lower could force European government MMF yields to go negative, thus challenging the viability of such a fund offering, especially those maintaining a constant net asset value (CNAV). For euro-denominated prime funds, these yield pressures will likely force managers to introduce or increase fee waivers in order to maintain the CNAV and a positive return on their existing funds.
European banks held €790.7bn on deposit with the ECB as of last Thursday. We expect a decrease in the deposit rate to encourage banks to shift these balances via lending to the real economy. However, this outcome is uncertain given the persistent macroeconomic challenges in the euro area. Until the deposit rate change becomes effective on 11 July, banks can continue to borrow from European money markets and, at a minimum, leave those borrowings on deposit with the ECB to earn 0.25%.
Following the ECB’s rate announcement, market information indicates that banks are reluctant to post borrowing levels for one-to three-month maturities, with any postings being at 0.00% and negative yields. How dramatic this rate move is for European MMFs will be more evident when the 0.00% deposit rate goes into effect.
Although the supply pressures and negative yields present obvious challenges to euro-denominated MMFs, managers have made efforts to alleviate the consequences of negative yields. During the past quarter, we have seen euro-denominated MMFs extend durations, enabling them to continue holding legacy investments that generate positive yields and appreciate in value as these securities reprice in the new rate environment and roll down the curve.