* 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 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
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
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
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."