Dollar funding pressure eases, but may come back

LONDON: Dollar funding costs for euro zone banks retreated from multi-month highs on Friday as the bloc's key policymakers looked closer to agree on how to bail out Greece, but interbank stress was likely to persist.

Germany's Angela Merkel and France's Nicolas Sarkozy, long at odds over how to involve the private sector in a new aid deal for Greece, said they had found common ground in the so-called "Vienna Initiative" -- a voluntary deal by banks to maintain their exposure.

The one-year euro/dollar currency basis swap spread, which expands when banks become less willing to supply dollars to each other, narrowed to 29 basis points from Thursday's 37 bps, the widest level in four months.

But risks remain in the short-term, with the Greek government facing a no confidence vote next week which may complicate the attempt to reach a bailout agreement in time to plug a financing gap next month.

In the longer run, economists say talk of losses being imposed on private Greek government bond holders could reignite again if the country does not meet its ambitious fiscal and privatisation targets and the swap can still test levels seen in May 2010, just before its first bailout deal was agreed.

"We've narrowed a bit (in FX basis spreads) today, but we are now looking for new equilibrium levels in the spreads and those are generally at wider levels than before," said Benjamin Schroeder, rate strategist at Commerzbank.

"I could imagine some scenarios where we could hit (the May 10 levels) again -- if they can't form a new government, if they cannot implement austerity measures then the next tranche of the new package would be an issue."

Eurodollar futures rose 4-5 bps higher across the 2011 strip after the Merkel-Sarkozy meeting, recovering some of the sharp falls seen earlier this week.

But Philip Tyson, head of rates strategy at MF Global, said funding pressures were likely to remain as Greece's situation was still "vulnerable and can deteriorate quite rapidly"

"(The falls) we've seen over the past few days have been just the start of the process. People have been comparing (the potential stress in money markets from a Greek default) to Lehman and yes, it can be huge because of the Greek contagion."

"We've recommended this morning a put spread for the December eurodollar contract at 99.25 and 99.00 from the current 99.55 just in case we start seeing yet more pressure in these markets," he said.

MECHANISMS IN PLACE

However, Tyson said that while stress indicators such as eurodollar futures and cross currency spreads could reach levels seen in 2010, both the European Central Bank and the Federal Reserve have mechanisms in place to avoid levels seen at the height of the Lehman crisis at the end of 2008.

The ECB has a dollar swap line with the Fed which can be activated, while it continues to provide euro zone banks with unlimited euro liquidity.

Abundant ECB cash is the reason why the spreads between Libor and Overnight Index Swaps -- a traditional gauge of counterparty risk -- have been stable at around 12 bps this week, compared with 25 bps in May 2010 and over 100 bps in 2008.

Morgan Stanley's head of European rates strategy Laurence Mutkin prefers spread wideners in cross currency markets to Libor/OIS wideners as a way to hedge against financing markets stress because the latter are kept low by ECB liquidity facilities, which makes the former a better risk proxy.

"The stress in dollar funding markets is likely to be higher than that in euro funding markets because the ECB can more easily ensure the supply of abundant cash to European banks," Mutkin said.

Copyright Reuters, 2011