Money markets stay locked; o/n rate soars

LONDON (Reuters) - The cost of borrowing overnight dollars on global money markets soared on Tuesday despite central banks pumping billions into the banking system to prevent it seizing up further after U.S. lawmakers' rejection of a S700 billion financial rescue bill panicked markets.

The scramble for cash as banks sought to square their books over the end of the quarter saw the European Central Bank lend $30 billion dollars overnight at a huge rate of 11 percent -- more than five times the Federal Reserve's 2 percent target rate -- and call for bids for an additional $50 billion.

Meanwhile, the London interbank offered rate (Libor) for overnight dollars jumped by a record 430 basis points to 6.87 percent, the highest in at least 7-1/2 years.

After the U.S. House of Representatives late on Monday rejected the $700 billion rescue package and sent Wall Street shares plunging, fears of further meltdown in Europe grew.

But in part buoyed by the Irish government's decision to guarantee all bank deposits and speculation central banks could cut interest rates in concert soon, a collapse of European equities failed to materialize.

European shares erased initial losses to trade largely flat on the day .FTEU3 .FTSE and U.S. stock futures pointed to a higher opening on Wall Street.

"Money markets are more of a problem than stock markets. Perceived counterparty credit risk ... probably won't go away for a while," said Everett Brown, strategist at IDEAGlobal.

He said interbank rates and premia over government borrowing costs and expected policy rates -- key gauges of financial market stress and investor risk aversion -- should come down from historically high levels in the coming sessions.

"They will come down a bit over coming days and weeks due to the U.S. package (probably) getting passed, more of these central bank liquidity operations going through, and the end of the quarter out of the way," he said.

The central banks of Japan, Australia, Britain and the euro zone injected liquidity into their respective banking systems on Tuesday to help banks meet funding obligations over the coming days, weeks and months.

A stark measure of banks' reluctance to lend to one another was their placing a record amount of overnight deposits at the European Central Bank on Monday worth 44.353 billion euros.

Reflecting the scarcity of funds in the interbank market, banks also borrowed 15.481 billion euros overnight from the ECB, the highest in almost six years.

"The financial system is self-destructing as we watch it, it's feeding off itself and it's hard to know what will stop it or what the financial infrastructure will look like when it's over," said Nomura rate strategist Sean Maloney.

COORDINATED RATE CUTS?

The Libor interbank cost of borrowing dollars for three months was almost a fifth of a point higher at 4.05 percent on Tuesday, with the premium paid over anticipated central bank rates (or Overnight Index Swap rates) widening to a record 247 basis points from around 219 on Monday.

Euro and sterling 3-month Libor/OIS spreads were both over 10 basis points wider and also at record levels.

"The movements have been so extreme the last few days we have to see some unwinding over the next few days, only when that is done will we be able to tell how much of what's been going on is structurally driven -- based on fear in the market -- and how much was just a quarter-end technicality," said Nomura's Maloney.

Australia, Britain and Europe are working to convince U.S. lawmakers to pass the $700 billion rescue package, which would allow the U.S. Treasury to buy up bad debt from banks, Australia's prime minister, Kevin Rudd, said on Tuesday.

The growing calls for closer cooperation are extending to potential coordinated interest rate cuts from the Fed and European central banks, even though they'd only do so as a last resort to instill confidence in financial markets, analysts say.

"There is a decent chance that European central banks ... will make emergency easing soon, perhaps this week, especially if the Fed is also ready to cut again," Citigroup strategists wrote in a note.

"Early easing (i.e. this week or next) may help reduce risks of a really severe financial collapse and deep recession (depression?)."

Interest rate futures markets are pricing in a two-in-three chance the Fed will cut rates by 50 basis points to 1.5 percent by or at its October 29 policy meeting.

Markets fully expect the ECB to cut a quarter point to 4 percent by the end of the year and to 3.75 percent by February.

(Additional reporting by Chikako Mogi in Tokyo, Michael Perry and Wayne Cole in Sydney and Ros Krasny in Nebraska)