MONEY MARKETS-Europe dollar funding costs near 2008 crisis levels

Fri Nov 25, 2011 11:04am EST

* Euro/dollar one-year cross currency basis swap near 2008 levels

* Key measures of financial stress remain elevated

* Italian auction highlight governments difficulties

LONDON, Nov 25 (Reuters) - The cost to European banks of swapping euros for dollars for one-year paper on Friday rose near levels seen during the height of the 2008 credit crunch as policymakers' failure to arrive at a crisis solution risked freezing inter-bank lending.

Italy paid a record 6.5 percent to borrow money over six months on Friday rounding off a week of disappointing auctions that saw the yields on both peripheral and core bonds rise sharply.

Banks were still reluctant to lend to each other, resorting to funding from the European Central Bank, as contagion took a toll even on the debt of Germany, the euro zone's paymaster.

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, was at -104 bps -- close to expensive levels of -115 bps in late 2008. Markets were thinned one day after a Thanksgiving public holiday in the United States.

"The deterioration in cross currency swaps has to do with the deepening of the sovereign crisis. Now we are entering into a new phase, where it is really moving to the core, so I think European banks ... will struggle more to get money," Alessandro Giansanti, strategist at ING.

Contagion has recently spread to triple-A rated debt such as that of Austria and the Netherlands. This week market pressure turned on Germany after one of its worst bond sales since the launch of the euro..

Its safe-haven status is beginning to be undermined by policymakers inability to provide a solution to the spiralling debt crisis, which could lead to the euro zone's break up.

"They need to stop the peripheral countries' blowing out and the only real way they can do that is via euro bonds, which the Germans don't want to do," one trader said. He added there was no cash at all in money markets.

On Wednesday he European Commission was seen as paving the way towards a common euro zone bond by proposing new laws that would grant intrusive powers into national budgets and tight rules on states' borrowing levels.

Joint bond issuance is increasingly seen as a viable long-term solution to the crisis, but Germany fiercely resists the idea for fear that it will have to foot the bill of common guarantees.

STRESS

For Giansanti, the only way money markets will stabilize is when European banks -- big holders of peripheral debt -- assume all of the losses from those exposures on their books and come up with a recapitalization plan.

The ECB is looking at extending the term of loans it offers banks to 2 or even 3 years to try to prevent the euro zone crisis precipitating a credit crunch that chokes the bloc's economy, people familiar with the matter say.

Not even that prospect was enough to soothe jittery money markets.

The fact the ECB is mulling this "is a clear indication that there is a lot of stress in the market," Giansanti added.

The spread between three-month euro Libor rates and overnight indexed swap rates -- an indicator of financial stress - kept near its highest since early 2009. The spread intra-day stood at 86 basis points not far from a high of 90 bps hit on Nov. 3.

The U.S. equivalent stood at its highest since mid-2009 at 40 basis points intra-day.

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