Wednesday, October 15, 2014

The Impact of Europe's Negative Interest Rates

Updated January 2015

Here is an interesting graph from the European Central Bank:

Notice that the first part of the curve has a negative yield?  Currently, the yields on 3 month, six month, nine month, and one to four year debt securities are negative, as low as -0.116 percent.  

This is what the same yield curve looked like back in October 2013: 

This is giving money market funds in Europe a bit of a nightmare.  With the ECB having imposted a negative deposit rate of -0.2 percent on reserves held at the bank, it becomes increasingly difficult for money market funds to keep depositors interested in investing.  Investors who don't want to see their deposits reduced by the negative interest rates are forced to withdraw their funds and hold cash.

The purpose of a money market fund is to give investors a completely risk-free instrument for their cash.  Money market funds invest in short-term securities, generally with terms of less than one year and are generally of the highest quality to protect the value of the fund.  These investments include commercial paper, certificates of deposit, bankers' acceptances and federal treasuries.  The maximum maturity of a money market fund is 364 days.  Money market fund shares are issued with a fixed unit value (the net asset value) and always maintain that value, paying out interest to unit holders so there is no capital gain (or loss) on the value of a unit since the value is fixed.    

According to the Telegraph, €500 billion held in money market funds is now in jeopardy because  negative interest rates are preventing the funds from making a profit.   In fact, one fund, BlackRock, the world's largest money manager, has invoked its reverse distribution mechanism in mid-September, a proposal that was introduced at a shareholders' meeting on February 11, 2013.  The reverse distribution mechanism allows BlackRock to "maintain a stable net asset value (NAV) for distributing shares, with shareholders having a reduced number of shares".  By triggering the reverse distribution mechanism, investors in BlackRock's €1.4 billion ICS Euro Government Liquidity Fund will receive fewer shares than they originally purchased so that BlackRock can protect the remaining assets in the fund.  This erosion of capital will certainly affect money market investors who expected a risk-free investment, however, the less palatable alternative to invoking the reverse distribution mechanism is to close the fund.

As the geopolitical and economic risks in the Eurozone rise, the current negative interest rate environment in Europe could put a significant strain on the continent's money market business.  This is also one of the key reasons why the Federal Reserve never cut rates below the zero percent mark; the affect on America's $2.591 trillion money market fund business would be catastrophic.

The tangled web of experimental monetary policies that the world's key central banks have woven in a desperate attempt to keep the world's economy afloat since the Great Recession is a ticking time bomb.  Sooner or later that bomb will go off, leaving another financial catastrophe in its wake.  Even those investors who thought that they were investing in the safest of instruments may be shocked to find that their portfolios were not as safe as they expected.

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