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The ESM and the case of the disappearing money market yields

The European Stability Mechanism’s entry as a short term debt investor later this month is likely to push already low yields down even further. With money market funds struggling in this environment, more could close — leaving issuers with a diminished natural investor base.

Who’d be a money market fund manager in today’s climate? Yields have tanked, investors are withdrawing cash and now a huge fish is about to start gobbling up what little supply is left in a rapidly evaporating pool of top rated issuers.

The European Stability Mechanism — the successor to the European Financial Stability Facility — is set to make a big splash later this month. It will receive €32bn of paid-in capital 15 days after its inauguration on October 8, some of which will be invested in short term money market assets with maturities of under one year. That will push down short term yields on top rated debt — already at zero or negative following the cut in the ECB’s deposit rate to zero in July — even further.

The ESM has the advantage that it can look down the maturity curve up to a year — money market funds’ liquidity requirements mean their use of longer dated buying is limited. Since the deposit rate cut, some funds have closed to new investment or have shut down entirely.

BlackRock, JP Morgan and Goldman Sachs all closed European money market funds to new investments in the wake of the deposit rate cut. Others have since followed suit.

Legal & General Investment Management’s LGIM Euro Liquidity Fund also closed to new money in July. However, the firm announced in September that the fund will be shut entirely on October 3 — and it is not alone.

The deposit rate cut was lambasted by many in the industry but it has forced some investors down the credit curve. Top rated money market funds are again prohibited from this approach due to liquidity requirements from regulators and ratings agencies. The funds have also been hit by ratings agencies slashing ratings and leaving funds with limited names to buy.

No one can blame the authorities for the temporary measures they have taken to tackle the eurozone debt crisis. This newspaper called for the ECB to go a step further and cut its deposit rate to below zero to further encourage investors towards periphery eurozone debt.

But the difference is that the ESM is not going away, in the near term at least. With a further €32bn of paid-in capital to be injected in mid-2013 and another €16bn in 2014 — reaching a grand total of €80bn — it is likely to remain a distorting effect on the money markets for some time.

Senior figures in short term debt have already raised concerns at some of the long term effects of the authorities’ short term solutions.

The ESM could be a hammer blow to money funds and permanently alter the landscape of the natural investor base for short term debt. A change in the political wind could also lead to the dismantling of the ESM — leaving short term issuers seriously short of demand.

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