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MONEY MARKETS-Escalating crisis fuels money market stress
August 3, 2011 / 4:45 PM / in 6 years

MONEY MARKETS-Escalating crisis fuels money market stress

* Key dollar interbank rate at its highest since May

* Key gauge of counterparty risks hover near two-year highs

* Financial stress in markets as euro zone crisis enters new phase

By Ana Nicolaci da Costa

LONDON, Aug 3 (Reuters) - The bank-to-bank cost of borrowing dollars for three months rose on Wednesday to its highest level since May as an escalation in the euro zone debt crisis prompted investors to ask for a higher premium to lend in interbank markets.

A key indicator of counterparty risks hovered near two-year highs as fresh signs of contagion added to concerns that the euro zone crisis may be entering a more dangerous phase where core economies come into the firing line.

The yield spread between 10-year Belgian and German bonds hit a euro life-time high, while Italian borrowing costs look set to overtake Spain’s in coming weeks as July’s euro zone deal failed to draw a line under the region’s woes.

“A lot of what we are seeing is driven by the demand for dollars of the European banks,” said Simon Peck, rate strategist at RBS. “It all ties in to the story of funding stress, which has been elevated at a time of increased systemic risk concern, which we are seeing now.”

The 3-month dollar Libor rate -- a key interbank rate for borrowing dollars -- fixed at 0.26828 percent, up from 0.26444 percent on Tuesday.

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, hovered around its widest levels since January.

NEW PHASE FOR CRISIS

With the possibility of an immediate U.S. default out of the way, analysts are now looking at developments in the euro zone, where the crisis seemed to be spreading beyond peripheral countries.

Euro zone leaders tried to ring-fence the debt problems in July when they announced a second rescue plan for Greece and gave the euro zone rescue fund more power.

The idea was to give officials more breathing room to get to grips with Greek, Portuguese and Irish debt problems in a way that would reassure markets that the euro zone debt crisis would not spread to countries too big to be bailed out.

Instead, yields on Spanish and Italian bonds held firmly above 6 percent levels, and now even core euro zone economies are feeling the pressure. Along with Belgian spreads, the French/German 10-year government bond yield gap hit fresh euro-era highs earlier.

Such concerns kept the spread between three-month euro Libor rates and overnight indexed swap rates -- an indicator of financial stress -- near its widest in two years. The spread was at 35 bps having spiked to 39 bps on Tuesday.

The equivalent dollar Libor/OIS spread was fixed at 14 basis points, 3 basis points wider on the day.

“We have seen some of the usual stress symptoms re-emerge,” said Christoph Rieger, rate strategist at Commerzbank.

“It’s quite clear the crisis is anything but resolved with banks keen to secure liquidity to just make sure they can weather the storm quite well.”

Financial markets will also look at the European Central Bank’s press conference on Thursday for any insight into whether the recent crisis developments -- and evidence of a global economic slowdown -- will have dampened the bank’s hawkish rhetoric.

The bank is almost certain to keep interest rates on hold this month after raising them to 1.5 percent in July, and Eonia forwards are not pricing in any hikes until next year, analysts said.

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