As new year resolutions go, ‘avoid losing money’ appears a fairly modest aim for most money managers. But even this humble goal will become increasingly difficult to achieve for European investors seeking a home for their cash in the face of negative — and declining — short-term interest rates.

Ever since the European Central Bank cut its deposit rate to below zero in June, Europe’s 1tn euros money market fund industry, a crucial reservoir of short-term finance for banks and companies, has struggled to maintain positive returns, in effect charging investors for putting their money in what are considered haven assets.

“Liquidity is becoming an asset class and having to pay for it is a paradigm change for investors,” says David Callahan, head of money markets at Lombard Odier.

Key short-term interest rates such as Eonia, which indicates overnight lending rates, and the Euribor one month rate yield minus 0.09pc and plus 0.01pc respectively.

By charging banks to park their surplus cash the ECB wants to encourage them to boost lending instead, particularly to smaller businesses

Nearly a fifth of short-term core European government bonds are yielding negative real returns as a result of the ECB’s policy, according to research by Morgan Stanley. Last week, five-year German Bunds also went negative.

The ECB’s purchases of covered bonds and asset-backed securities — to say nothing of government bonds potentially this year — could send yields even lower.

“The injection of liquidity via the ECB measures should push the Eonia rate further down into negative territory, thus creating the conditions for a further reduction in short-term rates,” says Giuseppe Maraffino, director of money market research at Barclays.

Yields on top rated corporate bonds could also tumble into the red.

“There’s no reason it should just be restricted to government bonds — very safe corporates could see the same thing,” says one London-based rates strategist.

The rate declines followed the decision by the ECB to start charging for access to its deposit rate — the first central bank in the world to take such action. In September, the ECB increased its levy on banks from 0.1pc to 0.2pc. In December Switzerland’s central bank also introduced a negative rate on deposits to ease pressure on the franc.

By charging banks to park their surplus cash the ECB wants to encourage them to boost lending instead, particularly to smaller businesses.

It also has the secondary effect of weakening the euro and thus potentially giving exporters a fillip.

“Negative yields encourage foreign investors to sell, thereby weakening the currency,” says Anthony O’Brien, co head of European rates at Morgan Stanley.

After three years of net annual outflows from European money market funds, the trend looks set to reverse in 2014. The industry had recorded net inflows of about 5bn euros by the end of September, according to Moody’s.

In spite of slim or non-existent returns, investors continue to find money market funds attractive, in part as a relatively safe way to hold cash but also because some custodian banks are charging clients to deposit their cash reserves.

“Money market investors mostly focus on preservation of capital and people will continue to pay for the privilege,” says Morven Jones, head of European debt markets at Nomura. “They are not paid to take credit risk.”

Greater demand poses another conundrum for ultraconservative investors: the relative dearth of high quality short term assets to invest in. The shortage means money market fund managers are being pushed to take greater risks, for example by extending the average maturity of assets.

“The increase in liquidity, as well as the reduction in short rates to zero or negative levels, has already led investors to take more credit and duration risks to get some yield pick-up,” says Mr Maraffino. “Such a process is likely to continue, and this might push yields even of risky assets further down.”

As alternatives go the obvious one is to hoard physical cash — whether under the mattress, or in a vault or safety deposit box. In September Benoît Cœuré, a member of the ECB executive board, addressed this possibility directly. He pointed out that when investors include ‘the cost of renting, maintaining and securing storage facilities such as vaults as well as the cost of shipping currency around in a safe and timely manner’, the extra expenditure was not worth it.

But that could change if Mario Draghi, ECB president, breaks his self-imposed ‘lower bound’ of minus 0.2pc on deposits and the floor descends further beneath investors’ feet.

“Demand for money market assets will wane . . . investors will forgo it,” says Mr Callahan. “People will not be willing to pay for an instrument they see as a cash buffer.”

Published in Dawn, Economic & Business, January 12th, 2015

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