Money markets stuck at crisis levels as U.S. plan eyed

LONDON (Reuters) - The estimated cost of borrowing dollars on seized-up interbank markets remained at crisis levels on Thursday, as nervous market participants awaited developments from Washington on a $700 billion U.S. financial bailout plan.

Congress is discussing the Treasury's proposals to take troubled assets off banks' books, a move seen as critical in restoring confidence between banks in each others solvency and in encouraging them to resume lending to each other.

The details of the plan remain sketchy and last-minute political wrangling over the size, terms and reach of the bill is intense.

Market participants report virtually no interbank lending beyond periods of a week or two, a paralysis exacerbated by the looming turn of the third quarter and with benchmark three-month funds maturing and needing refinancing in Christmas week.

"We have been seeing substantial evidence that banks are unwilling to make loans to each other," Bank for International Settlements chief economist Stephen Cecchetti told Reuters late on Wednesday.

"European banks don't want to borrow or lend from each other. The people who are left with extra would rather deposit it than lend it out, and the people who are short can't borrow."

In London trading on Thursday, the interbank cost of borrowing dollars for three months was indicated in a huge range of between 3 and 4.8 percent.

Overnight dollar rates were closer to the U.S. Federal Reserve's 2 percent target rate but still high at between 2 and 2.80 percent, Reuters charts show.

The closely-watched Treasury/Eurodollar (TED) spread, or the difference between these market-based dollar rates and three-month U.S. government borrowing rates, fluctuated in a wide range of around 260 to 420 basis points.

That spread, seen as key indicator of financial market stress and risk aversion, ballooned last week to almost 500 basis points, the widest in over a quarter of a century.

Three-month U.S. T-bill yields hovered around 0.5 percent on Thursday.

Analysts said the absence of interbank lending activity makes it difficult to assess the accuracy of rates posted by banks and there has also seen big discrepancies between reported costs of funds and daily fixings of the London interbank offer rate (Libor), a key reference for financial contracts worldwide.

Some analysts say banks are deliberately overstating London interbank offered rates (Libor) so as not to lend, and some suggest others may be understating Libor rates to help reduce exposure on Libor-related liabilities such as swaps contracts.

The stress is spread well beyond rates for borrowing U.S. dollars, where there has been an acute shortage in Europe and elsewhere due to the scale of banks' dollar liabilities.

The premia paid for three-months in sterling over expected official policy rates has exploded, doubling in recent sessions to a record high of 150 basis points.

"Something will be agreed (in Washington), but the problem is there are some hurdles to overcome. The market is fragile, and needs some answer as soon as possible," said Guillame Baron, rates strategist at Societe Generale in Paris.

OVERNIGHT LIQUIDITY

In the interest rates swaps market, the two-year dollar swaps spread was around 150 basis points. That's down from Wednesday's record high of around 162 basis points but still historically extremely wide. Swaps spreads generally are also seen as an indicator of investor risk aversion and financial market turmoil -- the wider the spread, the greater the stress.

While all eyes are fixed firmly on Washington, close attention will also be paid to the British Bankers Association's Libor fixing between 1000 and 1100 GMT, where dollar rates are expected to continue rising.

Overnight money market rates have started to recede toward official target levels amid a flood of liquidity pumped into the banking system by central banks around the world.

But over the last week in Europe, banks have been making heavier use than usual of the European Central Bank's overnight deposit and lending facilities rather than circulating cash around markets.

"Tension on the overnight liquidity markets is not confined to the U.S.," BNP Paribas rates strategists wrote in a note Thursday.

"While overnight rates are now below policy thanks to the weight of liquidity being added, that liquidity is being hoarded, not recycled in the market," they said.

Euro-zone banks deposited just over 3 billion euros at the ECB overnight on Wednesday rather than lending it on the wholesale money market. On Monday, the figure was 5.965 billion.

Banks are also borrowing from the ECB's overnight loan facility, which attracts a punitive 5.25 percent interest rate, although lending dropped below 1 billion euros on Wednesday for the first time in a week.

Benchmark one-week, three-month and six-month euro rates all continued to rise on Thursday despite ECB liquidity efforts.

Key three-month Euribor rate jumped to a new near eight-year high of 5.119 percent from Wednesday's level of 5.066 percent.

The one-week equivalent increased to a seven-year high of 4.779 percent from 4.741 percent, while the six-month rate, which crucially covers the period over the end of the year, again hit a record of 5.296 percent.

All of these rates are far in excess of the ECB's 4.25 percent target rate.