Money market tensions recall credit crunch warnings

By Kirsten Donovan – Analysis

LONDON (BestGrowthStock) – Money markets tensed up on Wednesday — a warning sign when the financial crisis erupted two years ago — with some banks finding access to funding harder as fallout from the euro zone debt crisis spread.

The signs of stress prompted calls for the European Central Bank to act to protect euro zone lenders as it did in 2008 when central banks took over provision of banking sector liquidity.

Benchmark euro zone interbank lending rates posted their biggest daily rise in nearly a year and, in the forward market, the spreads between three-month Euribor rates and equivalent maturity OIS rates — a classic measure of stress — widened.

Front month Euribor contracts sold off and longer- dated contracts rallied as the market pushed back expectations of an ECB rate hike. Forward Eonia rates do not reach even 1 percent — the ECB refinancing rate — until August, compared with June last week.

“The growing dislocation across the euro zone government bond markets is feeding into wider peripheral repo markets and cross-currency spreads, showing the crisis is hitting bank credit and market liquidity in a repeat of the 2007/2008 crisis,” said Lena Komileva, head of G7 market economics at Tullett Prebon.

Trade in peripheral euro zone government bond ground to a halt this week on fears of contagion from the Greek crisis. The Greek repo market, a key source of funding for domestic banks, has been all but shut for much of 2010 and this week the Spanish market also began to show signs of stress.

Further stress on bank funding is likely to come from the effective shut-down this week of the primary bond market for banks, particularly those in Southern Europe, while forward cross currency swap rates between euros and dollars reflected increased demand for the greenback. Traders said some banks were having to pay up to swap euros into dollars.

“Banks across Europe are well endowed with sovereign debt, all of which now look very dangerous considering how fast spreads have moved,” said Geoffrey Yu, an FX strategist at UBS.

Euro zone banks currently have access to unlimited shorter dated liquidity from the ECB, allowing them to meet capital requirements.

Indeed take-up at the central bank’s first competitive tender three-month funds on Wednesday drew demand for less than 5 billion euros out of the 15 billion on offer but a maximum bid rate of 1.5 percent showed how some banks were willing to pay up for longer-term funding.

Banks also increased their use of a seven-day facility this week by around 5 billion euros.

“The additional…demand is likely due to Greek banks, (which are) at risk of both suffering a further erosion of their deposit base and seeing a heightened probability of being collateral constrained at some stage,” said Societe Generale rate strategist Ciaran O’Hagan.

WILL THE ECB STEP IN?

The ECB has been taking steps to withdraw excess liquidity but talk is of what the central bank may do to contain the fallout and stop the sell-off of peripheral euro zone bonds.

“Liquidity withdrawal is off the table,” Commerzbank rate strategist Christoph Rieger, adding access to unlimited ECB funds at a fixed rate could be extended beyond October.

Others thought the ECB would have to take more drastic measures, possibly stepping into buy peripheral euro zone government bonds, effectively quantitative easing.

“The solution has to be a euro devaluation through the ECB purchasing peripheral euro zone government bonds,” said Tullett’s Komileva.

The ECB stepped in last year to buy covered bonds when liquidity in the market dried up.

“If the Greek crisis renders the bond market inaccessible for any other euro issuers, (the ECB) has an infrastructure in place for buying bonds via the central banks,” said Peter Chatwell, rate strategist at Credit Agricole CIB.

The forward September three-month Euribor/OIS spread has widened 10 basis points to 30 basis points this week.

One-year forward euro/dollar cross currency spreads widened to 37 basis points from 30 basis points, one trader said.”

“This basically means that funding is stressed and the market wants dollars,” said Yu. “This is less of an interbank issue, but another sign that liquidity is becoming a problem.”

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Money market tensions recall credit crunch warnings