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MMFs face potential yield and supply challenges following ECB action, says Moody’s

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Prime money market funds (MMFs) denominated in euros are challenged by the prospect of low yields and a potential reduction in short-term debt supply following the ECB’s decision to lower interest rates, says Moody's Investors Service.

The changes, which took effect on 11 June 2014, will result in a negative rate that will apply to reserve holdings in excess of the minimum reserve requirements and certain other deposits held with the Eurosystem.
 
Since the announcement of ECB measures, Moody's notes that the Euribor credit curve has shifted lower but remains positive and upward-sloping. The rating agency therefore expects that prime MMFs (those not restricted to investing only in highly rated government securities) will continue to be able to generate positive total returns. However, Moody's also observes that the low yields could increase exposure of MMF portfolios to longer-dated securities and/or riskier assets.
 
MMF managers expressed concerns that banks' issuance of short-term debt will decline because of additional excess liquidity; however, Moody's says that the policy changes announced last Thursday are unlikely to significantly alter its economic or financial outlook for the euro area.
 
Given banks' strong competition for deposits – a relatively cheap and stable source of private sector funding – Moody's expects that the ECB rate cuts will not be passed on one-for-one to households and businesses, and says it is unlikely that large numbers of banks will charge negative deposit rates.
 
Nonetheless, MMF managers are preparing for the possibility of large inflows into MMFs if banks were to start charging negative interest rates on deposits held by institutional clients. Material new inflows pose a risk for MMFs because large amounts of capital invested at lower yields would dilute the returns for existing clients.
 
Indeed, several MMF managers have said they would likely respond by limiting subscriptions in the event of large inflows.
 
However, even in the unlikely event that banks would start to apply negative rates to deposits, bank customers might prefer to shift their funds to higher-yielding instruments other than MMFs.

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