MONEY MARKETS-Positioning for a new round of euro zone stress

Fri Apr 13, 2012 9:04am EDT

* Concerns about banks vs sovereign relationship rise

* Money markets may face a new round of stress

* Strategists looking for creative ways to position for it

* Long end of the curve and relative plays favoured

By Marius Zaharia

LONDON, April 13 (Reuters) - Money market players are positioning for a new round of financial stress as concerns over euro zone banks' exposure to Spanish and Italian government debt mount, with the duo witnessing fast-rising borrowing costs again.

Data showed on Friday that Spanish banks borrowed a record 316.3 billion euros from the European Central Bank in March as they leant heavily on cheap three-year ECB loans due to a lack of market funding avenues available to them. Italian banks also borrowed a whopping 270.1 billion, earlier data showed.

Judging by the rally in Italian and Spanish government debt seen at the start of last year, analysts assume that a lot of the cash taken from the ECB has been placed in debt issued by the two sovereigns.

But as concerns rise over Spain's ability to enact fiscal discipline without sending its economy into a deeper recession, the contagion risk has taken centre stage again and Spanish and Italian yields have been rising since mid-March.

This leaves domestic banks exposed to sovereigns whose credit worthiness is weakening in the eyes of many. If banks started selling those bonds to stop losses or to get cash to pay back their own debts, borrowing costs for Italy and Spain would rise even faster towards unsustainable levels.

As the euro zone's financial system is strongly intertwined, the impact would be felt throughout the bloc.

"There is an increased strength of the nexus between banks and the sovereigns," RBS rate strategist Simon Peck said.

"We're going to see an environment whereby at some points in the future (banks) have to liquidate their sovereign holdings to cover redemption needs. The consequence is that when things do turn around, market moves are exacerbated."

HOW TO PLAY IT

With so much liquidity in the banking system already, short-term money market rates are likely to remain stuck around very low levels - and strategists have to be more creative than usual to make profits on bets for more money market stress.

The best way to position for it is at the longer end of the money market curve, which is less influenced by the excess cash lingering around in the banking system, they say.

Peck recommends betting on a widening of the spread between long-term forward rate agreements (FRA) and overnight index swaps (OIS), a forward-looking measure of counterparty risk based on derivatives of the interbank Libor and overnight Eonia rates.

To focus this trade on the long end of the curve, he specifically recommends a contract targeting a bigger difference between the two-year FRA and OIS rates starting in two years time. The 2y2y forward FRA/OIS last stood at 32 basis points and could widen to 75 bps, Peck said.

Societe Generale's head of fixed income strategy Vincent Chaigneau also said short-term rates and other derivative products based on them are likely to remain inert in the near future.

But he noted that when stress increases, the FRA/Eonia spreads tend to widen relative to FRA/Sonia, their UK money market equivalent, and recommends paying the three-month FRA/Eonia June 2012 contract while receiving the FRA/Sonia June 2012 .

The difference between the two contracts was 14.5 basis points on Friday. SocGen started the recommendation at 15.5 bps with a 0 bps target and a 20 basis points stop-loss level.

"There's a feeling that there are not going to be liquidity problems in the near term. All the (bonds that banks) bought - if they need liquidity they can sell those bonds. They will take losses as bond prices have declined but that protects their liquidity," Chaigneau said.

"It is a concern that Spanish and Italian banks have increased sovereign exposure so much ... and the (FRA/OIS) complex cannot be immune to the troubles that we see in the sovereign space again."

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