Money market stress fuels demand for ECB funding

A key measure of financial stress neared its highest level in almost three years on Tuesday as eurozone banks' reluctance to lend to each other drove demand for weekly central bank funding to a new two-year high. The European Central Bank failed to sterilise the full value of its eurozone government bond purchases on Tuesday, which analysts said added to signs of stress in the banking sector.
Banks have been hoarding cash instead of lending for fear of one another's exposure to the eurozone debt market, where yields continue to rise. Italy's borrowing costs hit fresh euro lifetime highs above 7 percent at debt auctions on Tuesday. "What seems to be clear is that some banks don't have access to the interbank market anymore," Benjamin Schroeder, strategist at Commerzbank, said. A total of 192 banks took a combined 265.5 billion euros at the ECB's once-a-week handout of limit-free seven-day loans. That amount tops the 247 billion euros that 178 banks took last week and marks the second week running in which demand has hit a new two-year high.
The spread between three-month euro Libor rates and overnight indexed swap rates - an indicator of financial stress - stayed close to its highest in nearly three years. It hit 87 bps in intra-day trading, nearing the 90 bps hit in November, its highest since March 2009. Meanwhile, the cost for European banks of swapping euros for dollars for one-year edged closer to levels hit at the height of the credit crunch in 2008.
The euro/dollar one-year cross currency basis swap, which widens when lenders charge more for swapping euro interest payments on an underlying asset into dollars, stood at -108 bps, its most expensive level since -115 bps in late 2008. Meanwhile, the ECB managed to drain only 194 billion euros from banks versus a target of 203.5 billion euros - the total amount the ECB has purchased through its bond-buying programme. It is not the first time this has happened and analysts say, judging by past operations, that the ECB could reclaim the shortfall in a week's time.
But the incident highlights the tough choices the ECB will soon have to make about printing money to revive a struggling economy. With Germany's backing, the monetary authority has resisted international calls for it to play a more aggressive role in tackling the crisis through more forceful bond buying.
But some analysts say the ECB has only a limited capacity to sterilise the bonds it purchases and is accumulating, beyond which point it would have to decide on outright quantitative easing (QE). Economists polled by Reuters earlier this month saw a 48 percent probability of QE in the eurozone.