Money markets longer term rates seen low for a prolonged period

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Investors dissatisfied with short-term interest rates of close to zero are increasingly seeking derivative instruments carrying longer maturities, taking the risk of a sudden shift in central bank policy. Record low official European Central Bank interest rates and excess liquidity in the euro zone system of 750 billion euros, according to Reuters calculations, have pushed money market rates to record lows. Speculation that the ECB could cut its deposit facility rate below the current zero percent, meaning investors would pay a fee to park their money, is putting even more pressure on rates. The overnight euro interbank rate, Eonia, last fixed just below 0.1 percent. Forward financial contracts that represent bets on where Eonia is going to settle at certain points in the future see the rate below 0.1 percent for the next two years.

Searching for higher returns, investors are moving towards longer duration. This week, for instance, the four-year Eonia narrowed by 10 basis points to 0.40 percent."Generally what we are seeing is that because you get next to nothing in the front end, people are willing to take on more risk and switch to longer durations," one trader said. Commerzbank rate strategist Christoph Rieger recommends bets that the 1y1y Eonia forward -- a financial product that targets the level of a one-year Eonia contract starting in one year's time -- will fall to last month's lows of just above 10 bps from around 20 bps.

"Even if the ECB does not cut the depo rate further, which remains our base case, prospects of unchanged rates, abundant excess liquidity and potentially lower EONIA-depo spreads should be enough reasons to expand into this part of the curve," he said in a note. Societe Generale rate strategist Ciaran O'Hagan believes it makes sense to place similar bets even further out on the curve, even if the time period goes beyond the massive three-year cash injections made by the ECB last December and in February.

The main risk investors are taking is a possible pick-up in the global economy that could prompt central banks to reverse or discontinue some of their more radical experiments in monetary policy easing. But given the state of the world's major economies and the depth of the euro zone debt crisis, investors seem willing to take the risk."Central banks around the world are going to continue to provide liquidity," O'Hagan said. "The long-term challenges we're facing are so severe and so dramatic that at the moment this is how you want to be positioned."I'm not saying that you can't reverse these positions in a few months, but certainly for now you do want to be positioned long OIS (overnight index swaps)," he said, referring to trades in which market players position to receive overnight rates in the future via Eonia-based derivative products.