At a time when large European corporates hold record levels of surplus cash, the EUR money-market business is under pressure from low/negative interest rates: during the second half of 2014, the yields of those money-market instruments considered to be either the safest/most liquid and/or with the shortest maturities (below three months) gradually slid into negative territory.
As corporate treasurers take strategic decisions for 2015, they are confronted with numerous challenges about the choice of how they invest their surplus cash – a strategic asset in periods of crisis. Money-market funds constitute an option, provided that corporate treasurers have sufficient leeway in terms of their investment policy. Many investors are still examining opportunities in the wake of the ECB’s move to expand its balance sheet.
We note that one of the responses to current market conditions is, for many investors, an easing of their investment constraints. The growing appetite for money-market funds with longer investment horizons and more leeway in terms of credit and interest rate duration provide evidence of this trend. In our view these funds can help investors cope with market conditions in 2015.
The EUR money market faces a number of challenges
At the beginning of September 2014, the European Central Bank (ECB) cut its key rates to a record low in an attempt to ward off the risk of deflation in the eurozone. In 2015, attention will focus on the ECB’s unconventional policy measures aimed at enhancing the functioning of the monetary policy transmission.. The substantial quantitative easing announced by the ECB on 22 January encompasses a broader range of securities including eurozone sovereign debt. However, it is above all the ECB’s long-term refinancing operations (LTRO) and the resulting increase in surplus liquidity in the interbank market that will determine short-term interest rate trends in 2015.
Exhibit 1: Graph showing the liquidity surplus in the eurozone interbank market.
The liquidity surplus in the interbank market corresponds to the amount borrowed from the Eurosystem by eurozone bank above their liquidity needs.The trend in surplus liquidity is an important indicator as it can affect money-market rates: the larger the liquidity surplus, the greater the difference between the refinancing rate and the Eonia rate (i.e. the lower the Eonia rate will be).
For the following reasons the liquidity surplus and, consequently, the Eonia fixings are likely to be increasingly volatile over the coming months:
First of all, after the full repayment of the first 3-year LTRO at the end of January 2015, the second 3-year LTRO is due to expire on 26 February 2015 (total outstanding of EUR 117.5 billion as of 04/02/15): this could drain part of the surplus liquidity in the interbank market (which in early February 2015 amounts to around EUR 173 billion) and could, in theory, be expected to have a positive impact on Eonia fixings.
Starting in March 2015, further targeted LTROs are due to take place each quarter. These could have a negative impact on short-term rates. A significant increase in liquidity surpluses in 2015 could push Eonia fixings towards their floor rate, i.e. the ECB deposit facility rate, which has been set at -0.20% since September 2014. Note that the first two TLTROs in September and December 2014 were not an unmitigated success, with demand from banks falling short of the consensus forecast and well below the maximum allowance.
As of 3 February 2015, the market anticipates an average Eonia rate of around -0.10% for 2015 as a whole (12M Eonia swap rate).
Exhibit 2: Changes in the 12 month Eonia swap rate for the period from 01/01/13 to 30/01/15
Source: Bloomberg, BNPP IP, as of 30 January 2015
This overnight rate, which is a benchmark for many corporate treasurers investing in the EUR money market, is nonetheless expected to remain very volatile. Eonia fixings could therefore occasionally drop below -0.10% from the first quarter of 2015 onwards.
Among the other major challenges that could affect money market investments in 2015, we note:
The significant tightening in credit spreads of money market instruments since the summer of 2014, particularly in the segment of six to twelve month maturities: this trend has continued so far this year.
A dwindling supply of money market instruments: the reduced supply results mainly from the surplus liquidity in the interbank market, the focus of banks on longer maturities in order to meet liquidity ratio requirements, record levels of cash surpluses at major non-financial companies and the rating downgrades of a number of bank, corporate and sovereign issuers.
The high valuations of those instruments considered to be very liquidity such as T-bills issued by the ‘core’ countries.
The regulatory debate still underway, particularly that relating to constant NAV money-market funds, could have an impact on the money-market fund industry.
‘Money-market’ funds hold their own
In this environment of historically low yields, EUR money-market funds remain an attractive alternative to direct investments in money market instruments. Money-market funds are very liquid (offering daily liquidity and same day settlement), offer a high level of diversification (issuers, countries and sectors) and enable investors to benefit from significant economies of scale.
Against a background of rapidly falling returns, most money-market funds, whether extremely conservative or with additional leeway in terms of interest-rate and credit exposure, benefited in 2014 from the yields on instruments purchased prior to the ECB’s rate cuts.
In the fourth quarter of 2014, some funds nonetheless recorded negative performances due to the renewal of securities reaching maturity (this was the case, for example, of funds invested exclusively in high quality sovereign securities).
Euro-denominated “Short-Term Money-Market Funds” on the whole recorded substantial levels of redemptions in 2014. AAA-rated funds in this category nonetheless continued to attract international investors subject to extremely strict investment constraints. The best performers in this category stood out, in 2014, by their more active management (fixed/floating arbitrage, longer credit duration), while complying with very strict investment constraints. However, the room for manoeuvre in 2015 looks to be extremely limited. Several of these funds are currently posting zero or negative performances (with in this case activation of the share reduction mechanism to keep NAV at €1 for AAA-rated constant NAV funds).
In 2014, Euro-denominated “Money-Market Funds” recorded significant inflows thanks to the continued shift in assets from “Short Term Money-Market Funds” toward funds with a broader opportunity set. The additional room for manoeuvre enjoyed by these funds (see exhibit 3 below) enabled them to respond to the expectations of investors looking for additional returns and with cash to invest over horizons of between one and several months. On average, institutional “Money Market Funds” outperformed the “Short Term Money Market Funds” category by around 20bp net of fees in 2014.
Exhibit 3: Table comparing the principal characteristics of the Short Term Money Market Fund category with those of funds in the Money Market Fund category.
In 2015, we expect returns to remain under pressure, particularly for “Short Term Money-Market Funds”. However, investment opportunities and the terms offered to corporate treasurers on bank deposits are also likely to contract, due in particular to the ECB’s quantitative easing to start in March 2015.
Some investors now seem prepared to accept negative returns on their safest and very short-term investments. In an environment marked by more expensive very short-term liquidity, we nonetheless expect to see an ongoing move towards more flexible investment policies allowing increased exposure to longer-term solutions. Given that the returns offered by “Money Market Funds” are currently around 10 to 15 basis points higher than those procured by “Short-Term Money-Market Funds”, we expect the former to continue to stand firm in 2015.
It should be noted however that the performances of the funds vary from one management company to another. This has enabled managers with significant resources in terms of analysis and who are capable of actively managing the risk envelopes at their disposal to stand out from the rest.
3 February 2015