Funding stress may rise without euro solutions

A Franco-German proposal for economic governance and euro zone integration this week did little to soothe investor concerns that the debt crisis will continue to spread as the immediate problem of funding for weaker countries remains unresolved, analysts said.

"(Markets) are concerned about a potential intensification of financial stress," said Philip Tyson, strategist at MF Global.

"I feel that the stress in the peripheral markets is bound to return at some point because we haven't seen any permanent solution," he said.

This could lead to "concerns about banks, in turn we will get potentially more stress in the money markets," he said.

The three-month US dollar Libor/OIS spread -- a measure of counterparty risk -- hit its highest level in a year at 19 basis points.

London interbank offered rates for three-month dollars continued their upward march, to hit fresh highs since April at 0.29778 percent from 0.29589 percent on Wednesday.

Highlighting tensions, the Wall Street Journal reported that the Federal Reserve Bank in New York was taking a closer look at the US units of Europe's biggest banks, out of concern the euro zone debt crisis could spill into the US banking system.

But William Dudley, the New York Fed Bank's president, said the institution was "always scrutinising" banks and that it treated US and European banks "exactly the same".

Matteo Regesta, rate strategist at BNP Paribas, said that would be a natural reaction from regulators after the European Central Bank saw demand for seven-day dollar loans for the first time in almost six months on Tuesday.

"Because the facility has not been used for quite some time I believe it has been requests just clarifying whether it's a one-off tap or if there is a heightened dollar funding pressure in the euro system," Regesta said.

"The point is we have indicators of stress in the market already and this tender alone does not add much if it's not followed by repeated access to the facility."

The spread between three month Eonia and three month Euribor -- a proxy between collateralised and uncollateralised lending in the interbank market and an indicator of strains -- fixed up at 65 basis points, compared with a year-to-date average of 28 bps, he said.

QUICK FIX

French and German leaders disappointed financial markets this week, signalling that a common sovereign bond, if it ever comes, would be a long way off and that instead they were focusing on more policy integration.

But a Reuters poll of economists taken this week suggests Europe's power brokers will have to face up to the reality that jointly-issued debt might be one of the few measures that can stem the sovereign debt crisis, which threatens to overwhelm some of the bloc's biggest economies. .

Tyson said financial stress was going to be a persistent problem until there were more concrete solutions to the crisis -- ultimately more integration and common bond issuance.

For now, he recommended some protection in the December eurodollar contract.

"You could look at some sort of put or put spread in December eurodollars just in case we do see Libor spiking higher again," he said.

"The contract at the moment is close to 99.50, so if Libor rises and the price of the contract falls, then your put spread should increase in value and so you have some protection on there."

Copyright Reuters, 2011