Interbank rates fall but momentum stalling on Greek unease

LONDON: Benchmark interbank rates hit new 23-month lows on Tuesday, pinned down by a glut of central bank cash, but improvement in measures of counterparty risk could stall as political risk in Greece stokes worries about which lenders are most vulnerable.

The ECB's injection of one trillion euros of three-year loans into the banking system since December has halved three-month euro-priced interbank rates, easing money market strain as the threat of another Lehman Brothers-style implosion receded.

But a political stalemate in Greece after weekend elections which could lead to the formation of a government opposed to the conditions of its international bailout was making money market participants cautious, subduing interbank activity.

Worries that Greece would be unable to pay its debt added to investor concerns that the sovereign debt crisis could again start seeping into money markets, distorting lending.

"The Greek situation is going to curtail interbank activity and make people more wary of counterparty risk. That's why we're seeing in wider markets more yield declines in German bonds and gold coming off," said Simon Smith, chief economist at FXPro.

"We're entering a new phase of uncertainty regarding counterparty risk as politics once again comes to the fore."

While three-month London interbank offered rates for three-month euros hit its lowest level since April 2010 around 0.61750 percent, its spread over Overnight Index Swap rates - a key barometer of counterparty risk - has been largely stuck around 30 basis points in recent weeks.

The equivalent dollar Libor has held steady at 0.46585 percent over the past fortnight, with the spread over OIS also little changed.

"The momentum is slowing down when you look at  Libor/OIS spreads. There's more stabilisation there. Libor/OIS is reflecting that we aren't going to see massive improvement from here," Smith said.

However, the glut of central bank liquidity is expected to keep money market strains from intensifying to levels anywhere near those seen in the second half of last year.

For instance, three month euro/dollar cross currency basis swaps, which shows the rate charged when swapping euro interest rate payments on an underlying asset into dollars, is still around its tightest in nine months at 49 basis points.

 The measure, which widens in times of funding stress when investors compete for dollars, has gradually tightened from November's minus 167.5, a level not seen since the aftermath of Lehman Brothers' collapse in late 2008.

"The only thing which will cause a massive step up in funding stress is if the Federal Reserve pulls its dollar swap lines with the ECB or Germany decides it has had enough of easing on the monetary and fiscal side," said UBS currency strategist Chris Walker. "Until that fundamentally changes, we're not going to see much in terms of funding stress."