MONEY MARKETS-Counterparty risk measure at lowest since mid-2007
LONDON, Sept 19
LONDON, Sept 19 (Reuters) - Central bank action helped push down a barometer of counterparty risk in the euro zone this week to its lowest since the U.S. subprime crisis started in 2007, but has done little to breathe life into frozen money markets.
The Bank of Japan on Wednesday became the latest central bank to ease monetary policy, by boosting its asset-buying programme. Its move came on the heels of the Federal Reserve's aggressive support measures and after the European Central Bank pledged potentially unlimited, though conditional bond buying.
The show of force has helped riskier assets, taking European stocks last week to their highest since July last year and pushing Spanish and Italian bond yields sharply lower.
It has also helped reduce the three-month spread between euro Libor rates and overnight index swap rates - an indicator of funding stress - but some say the move only partly reflects an improvement in funding conditions.
"There is a clear distortion, because those numbers suggest one story but the reality is very different ... if you consider the fact that European banks are reluctant to lend to one another," Chris Huddleston, head of money markets at Investec, said.
The difference between the rate of lending over three months and overnight in euros was last at 6 basis points, down from 7 bps the previous day and around its lowest since mid 2007, right before the U.S. subprime crisis took off in earnest.
But the narrowing from around 90 bps in December of last year has also been driven by technical factors, most recently a reduction to zero in the ECB deposit rate, which serves as a floor to the overnight lending rates.
Excess liquidity in financial markets after two rounds of cheap ECB financing this year has certainly made plenty of cash available to banks, but they are still not lending and the funds have yet to benefit the real economy.
"Banks just take the free money and what they do with it is they do carry trades, they just boost their balance sheets, they increase assets," an interest rate strategist at Citigroup, who asked not to be named, said. "European banks have increased their assets in the last 12 months by 7 percent, so there is no deleveraging process going on, it's just free-ride."
The move mirrored a trend in global money markets but was more pronounced than elsewhere.
The three-month dollar Libor/OIS and the sterling equivalent have more than halved since January to 22 bps and 24 bps respectively.
"The Libor/OIS spreads in the G3 currencies dollar, euro and sterling have declined massively especially since the end of last year ... mainly because there are various central bank measures that were introduced during (that) time," Max Leung, rates strategist at Bank of America Merrill Lynch, said.
Leung said given the inherent risk in the whole of the euro zone, not just the banking system, the euro Libor/OIS spread could be considered "artificially too tight."
But instead of widening, he expected that gap to narrow more, especially if the ECB does not cut the deposit rate further.
Eonia forwards suggest markets still see some chance of the ECB cutting the deposit rate to negative territory even though expectations were pared back after ECB President Mario Draghi did not given any guidance on this at the last monetary policy meeting.
In the absence of another deposit rate cut, Eonia rates would probably remain around current levels of 10 basis points, analysts say. If three-month Euribor rates continue to fall - as they have done recently on expectations of further cuts in the refinancing rate - Libor/OIS spreads could tighten closer to zero but Leung said the market would struggle to take it much lower.
"Whether you lend overnight or you lend over a fixed term, you are not gaining anything from the risk, so banks may be even less willing to lend to each other in that case on a term basis," Leung said.
This reluctance to lend would only be reversed if investors regained confidence in one another and on the economic outlook.
Outright quantitative easing was not a sufficient condition for this, as shown by the United States' experience, but was a necessary one, the Citigroup strategist said.
"If your target is to have a higher potential rate of growth and lower unemployment, then there is a necessary condition and this would be basically to engage in a Keynesian-style asset purchase," he said.
The prospect of this in the euro zone was pretty low however. ECB Governing Council member Luc Coene said on Monday it was "very unlikely" that the ECB would ever engage in outright quantitative easing.
Reuters stopped polling on that possibility as discussion of it happening in the market tapered off. Its last poll on potential unsterilized bond purchases was in December of last year when analysts saw a median 40 percent chance of it happening, down from 48 percent in a November poll.
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