September 19, 2008 / 8:54 AM / 11 years ago

UPDATE 3-Money mkts cautiously welcome sweeping US plans

(Updates with reaction to wide-ranging US rescue plans)

By Jamie McGeever

LONDON, Sept 19 (Reuters) - The deep freeze that paralyzed money markets this week thawed on Friday after U.S. authorities unveiled a sweeping range of measures to ease the financial crisis, bringing interbank borrowing rates and spreads down from historic levels.

The overnight cost of borrowing dollars fell, while the premiums over government rates and interest rate swaps spreads — both key measures of risk aversion and financial market stress — also fell steeply.

The cost of three-month dollars also eased, with ICAP’s New York Funding Rate falling to 3.3687 percent from Thursday’s 3.7125 percent.

The Treasury said on Friday it would use $50 billion to back money market mutual funds in the $3.5 trillion sector whose value falls below $1, and the Federal Reserve said it will lend even more cash directly to institutions to buy certain assets from money market funds.

This comes as U.S. financial and Congressional leaders are in talks to create a taxpayer-funded entity to mop up the toxic assets infecting banks’ balance sheets, and follows a $180 billion dollar liquidity provision from the Fed and other global central banks on Thursday. For more, see [ID:nN19459598] and [ID:nLJ263602].

While the long-term impact of lumbering the taxpayer with hundreds of billions of dollars of liabilities could be serious for U.S. fiscal health, analysts gave an initial welcome to the moves.

“Ring-fencing the money market funds would produce the double benefit of protecting private sector savings and averting a renewed spike in the interbank money market crisis,” said Lena Komileva, G7 strategist at Tullett Prebon in London.

Jim O’Neill, chief global economists at Goldman Sachs, said the measures pulled financial markets back from the brink. And analysts at Bridgewater Associates, a Connecticut-based fund management firm with $140 billion in global investments, said the safety net will reduce the risks of banking sector meltdown.

At 1500 GMT the cost of three-month interbank borrowing was indicated at around 3.20 percent USD3MD=. With three-month T-bill yields recovering to around 0.8 percent from 0.2 percent on Thursday and virtually zero earlier this week, the closely-watched ‘TED’ spread fell to around 280 basis points.

That spread briefly fell to around 200 basis points on Friday, having ballooned on Thursday to almost 500 basis points, the widest in over a quarter of a century.

LONG AND WINDING ROAD

In interest rates swaps markets, the two-year U.S. swaps spread fell to around 110 basis points USDSB3L2Y=RR US2YT=RR from a record high of around 155 basis points on Thursday.

The comparable euro zone swaps spread dipped to 92 basis points EURAB6E2Y= EU2YT=RR from a record peak of 125 basis points on Thursday.

Ten-year euro zone swaps spreads also fell from record peaks, by around 15 basis points to 70 basis points.

“If you think risk aversion will make a comeback over the next couple of weeks, spreads will tighten. We’re at very, very wide levels,” said Guillame Baron, money market strategist at Societe Generale in Paris.

In the interbank market, overnight London interbank offered rates (Libor) for dollars fell for a third straight day to 3.25 percent USDONFSR=, down from Thursday’s 3.84375 percent and almost half the extraordinary 6.43750 percent struck Wednesday.

Market-based overnight dollar rates also fell back toward the Federal Reserve’s 2 percent target rate, indicating relief at Thursday’s central bank liquidity action and growing hopes that a more comprehensive resolution to the crisis might be at hand from Washington.

Market-based overnight rates had surged to well over 10 percent earlier this week after the collapse of Lehman Brothers and bailout of American International Group.

But it wasn’t all so clear-cut, especially further out the curve.

Despite the fall in overnight dollar rates on Friday, overnight Libor remained 125 basis points above the Fed’s 2 percent target rate.

Three-month dollar Libor edged higher, while three-month euro Libor hit 5 percent for the first time in almost eight years and three-month sterling Libor regained a 6 percent handle.

For more on Friday’s Libor fixings, see [ID:nLJ432324].

“Even though markets recovered a bit, the stress in the financial sector is set to continue,” wrote Dresdner Kleinwort strategists in a research note.

Certainly, the road to recovery will be a long and rocky one.

Banks will continue to need the crutch of central bank liquidity for many months, more losses and writedowns are expected, and major economies are in or will go into recession. This should keep longer-term rates and spreads relatively high.

“Things do look better today, this is undeniable. (But) it’s not clear whether these (money markets) can recover given the mistrust inherent in the system now,” said David Keeble, head of global rates strategy at Calyon.

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