LONDON (Reuters) - U.S. money market funds are slowly returning to the euro zone, lured by a gradual rise in interest rates as the lenders grow more confident the bloc can contain its debt crisis.
For now, funds remain selective with the banks they lend to, preferring the security of those in the top-rated economies in case the three-year-old crisis flares up again.
Their renewed interest in the region is, nevertheless, re-opening an important funding source for banks, whose lending on to businesses is crucial to accelerating a fragile economic recovery.
Encouraged by the safety net of the European Central Bank's new, though so far unused, bond-buying program and slightly better than expected business sentiment, euro zone banks have begun to wean themselves off central bank support.
They have so far paid back nearly a third of the first emergency three-year loans (LTROs) taken from the ECB in November 2011, creating expectations the excess cash in the euro zone banking system may shrink faster than initially thought.
This led to a rise in money market rates and an opportunity for U.S. funds to step back in, after almost turning off the tap on the euro zone in July, when the ECB cut its deposit facility rate to zero, pushing market rates into negative territory.
"We definitely think things are improving from an economic perspective and that's probably what's driving rates higher," said Deborah Cunningham, chief investment officer at Federated Investors, a firm managing $285 billion in money funds.
"With the payback of LTROs by the various banks, they're going to need some direct financing coming from the market rather than from the ECB...That's going to increase the supply that we will have to choose from over there," she said, referring to euro zone banks' borrowing requirements.
Borrowing from a fund is cheaper than from the ECB.
With the past six months' rise in euro zone market interest rates, she was planning to "put more money at work" in both euros and dollars for longer, having previously restricted loan lengths to no more than a month.
Money market traders said they had seen increased lending in maturities of three and six months and even noticed some one-year trades in January, a rare sight during the crisis.
Six-month Eonia rates, which reflect the average expected overnight rates during the period and often move in tandem with rates on similar-dated commercial paper issued by the region's strongest banks, last traded at about 0.12 percent, compared with a low of minus 0.03 percent at the end of July.
One-year Eonia rates are about 0.18 bps, while one-year benchmark euro Libor rates are below 0.50 percent. Banks repaying their long-term ECB loans after one year are charged just over 0.75 percent interest.
Back in July, money market funds, which use investors' money to lend to banks, companies or governments for short periods -- typically less than two years -- struggled to offer any returns. At negative rates, a lender is effectively penalized.
JPMorgan Chase & Co, BlackRock Inc and Goldman Sachs Group Inc, restricted investor access to their European money funds, immediately after the ECB's deposit rate cut. JPMorgan said it has since lifted most of the restrictions. The other two firms still have them in place.
A survey by Fitch Ratings published in January showed, without providing detailed figures, U.S. prime money market funds' exposure to the euro zone at the end of 2012 was more than 70 percent higher than six months earlier, due to "ECB actions and a general softening in euro zone market volatility".
Allocations to the region probably rose further in January. Wells Capital Management, which manages $136 billion in money market assets, has increased exposure since the start of 2013.
"Near-term there has been ... sufficient confidence inspired to investors that things are going well," said David Sylvester, the company's head of money funds.
But Fitch said euro zone exposure was still more than 60 percent below end-May 2011 allocations, when three- and six-month rates were above 1 percent, and was unlikely to regain those levels any time soon.
Later in 2011, benchmark borrowing costs in Italy and Spain reached unsustainable levels, raising doubts the currency union would survive. The subsequent flight of U.S. money funds from Europe raised fears about the health of the euro banking system.
The three-month euro/dollar cross currency basis swap, which measures the cost of swapping euro funding for dollars, hit its most expensive levels since the collapse of Lehman Brothers at minus 167.5 basis points in November 2011. The cost has since tumbled to minus 23 bps.
Concerns about the debt crisis, even if subsiding, remain and keep many fund managers cautious about the euro zone.
"Rates have been slightly better, but we would like to see a longer period of improvement," said one money market funds provider, who asked not to be named. "It does look like rates are bottoming out, but the situation remains fragile and it could just as easily flip back."
The major worry is that the improvement in euro zone data is mainly driven by the stronger economies, while others still have major structural weaknesses.
"We just feel there's more writedowns to occur there," said Cunningham of Federated, which does not invest in lower-rated euro zone countries.
(Editing by Nigel Stephenson)
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