Stress keeps dollar funding costs at 4-mth highs

LONDON: Worries the euro zone debt crisis could spread to France kept dollar funding costs for European banks high on Friday, and a partial short-selling ban on shares did nothing to ease already elevated levels of money market stress.

Benchmark three-month dollar funding costs hit fresh four-month highs after a week of worries about the health of France's banking system, which prompted one bank in Asia to cut credit lines to major French lenders, according to a Reuters report. .

A ban by some national regulators on short selling of financial shares helped stabilize global financial markets on Friday, but it could increase tensions on money markets over time, some analysts said.

"One of the by-products that you get from the short selling (ban) is that, because (players) can't hedge their counterparty risk by short selling or taking positions in the counterparties, they tend to hoard liquidity," said Charles Diebel, head of market strategy at Lloyds Bank.

The London interbank offered rate on three-month dollars hit fresh four-month highs of 0.29006 percent versus 0.28617 percent on Thursday.

The three month euro/dollar cross currency basis swap pulled back from recent lows but hovered near levels last seen in 2008.

It stood at -86 bps, having hit a low of -98 basis points earlier in the week. This, however, was still a way away from -300 bps seen at the height of the 2008 credit crisis.

"There is system-wide stress and no amount of  interfering with market functioning is going to change that fact," said Havinder Sian, rate strategist at RBS.

"There was a risk of a spiral and I think they've acted to prevent that," he said. "Medium term you still have the counterparty risk to deal with.it probably means that you are looking to reduce exposure as an institution to risks that you are not comfortable with."

Market participants did not expect the kind of financial stress seen after the collapse of Lehman Brothers but money markets should remain fragile for some time.

Uncertainty remained over just how bad things could get in the euro zone: there was no imminent solution to the debt crisis, the European Central Bank were having to buy Italian and Spanish bonds to keep their funding costs sustainable and worries of a global slump persisted.

"The Libor-OIS spreads have widened and I think that it's a trend that we can see persisting," said Sian referring to the three-month euro Libor-OIS forward spread which he said had widened to 61 basis points on Friday from 58 basis points on Thursday.

The spot spread between three-month euro Libor rates and overnight indexed swap rates an indicator of financial stress meanwhile was fixed at 60 basis points, pulling back from extremes of 68 bps on Thursday.

Elaine Lin, sovereign and money market strategist at Morgan Stanley, said the biggest concern was medium- to long-term funding rather than short-term liquidity as the risk of a solvency problem in the euro zone increased.

"Italy and Spain are currently being supported by the ECB and at the same time French sovereign CDS is still under pressure," Lin said. This shows "how worried the market is about contagion risk and that's not something that can easily be fixed," she added.

The cost of insuring French debt against default was at 147 basis points, up from 108 basis points in early January.

Copyright Reuters, 2011