Central Banks Calm Overnight Money Market
But Tensions Remain

JAMIE McGEEVER / Reuters 18sep2008

LONDON — Aggressive coordinated central bank action on Thursday to revive paralyzed money markets is likely to achieve its aim of capping overnight dollar rates, but longer-term interbank rates are unlikely to fall as steeply.

Analysts welcomed the liquidity injections and currency swap agreements to pump tens of billions of dollars into the international banking system, but warned they did little to aid the process of reducing banks' debt, risk and balance sheets.

As a result, banks will remain wary of lending to each other for periods longer than a few weeks, which in turn will ensure money market liquidity remains scarce and the cost of term financing high.

"The issue is deleveraging," said Francis Yared, rates strategist at Deutsche Bank in London.

"There are more problems with three-month rates but even if they (central banks) do fix them there's still the deleveraging overhang."

Laurence Mutkin at Morgan Stanley also welcomed the action but pointed out that money market conditions have deteriorated so much this week that these steps will prove no quick fix.

"This action should do a lot: it demonstrates central banks' coordination and resolve, and by bringing down overnight rates it at least gives the term interbank market a chance of re-opening," he said.

"(But) it may be that the recovery from yesterday does not happen fast enough without further central bank action. If so, I expect to see more from the central banks, and to see it quickly."

For more on the central banks measures see [ID:nLI348579]. The moves helped ease some of the immediate pressures suffocating money markets.

The interbank cost of borrowing dollars overnight fell on back toward the U.S. Federal Reserve's target rate of 2 percent <USDOND=> and three-month rates eased to around 4.5 percent from 5 percent <USD3MD=>.

Two-year U.S. swap spreads, the gap between interest rates swaps and Treasury yields, fell back to 115 basis points from record highs around 133 basis points <USDSB3L2Y=RR> <US2YT=RR>.

And the difference between borrowing three-month dollars on the interbank market and the U.S. Treasury's three-month borrowing costs, the so-called 'TED spread', narrowed by around 40 basis points to 450 basis points <US3MD=> <US3MT=RR>.

SOLVENCY, LIQUIDITY FEEDBACK LOOP

But these retracements must be put into the context of the unprecedented turmoil in the U.S. financial system that saw Wall Street giant Lehman Brothers collapse, authorities essentially nationalise insurer American International Group, and investors stampede into the safety of T-bills after a money market fund's net asset value "broke the buck" below $1.

Before the central banks' announcements on Thursday the TED spread was at almost five percentage points, the highest in at least a quarter century and more than double the previous peaks reached during the 13-month financial crisis.

The two-year U.S. swaps spread was at record levels too.

Even after the news, staggering demand for dollars at the European Central Bank dollar auction and for sterling at the Bank of England's weekly money market operation reflected the acute need for cash in the banking system.

A total of 61 banks bid for over $100 billion at the ECB's auction of $40 billion, and UK banks bid for over 200 billion pounds at the BoE's weekly tender of 66 billion pounds.

The British Bankers Association's daily fixing of London interbank offered rates (Libor) showed that three-month sterling Libor had its biggest jump since August last year, and the premium of three-month dollar Libor over anticipated central bank rates as measured by Overnight Index Swaps (OIS) ballooned to a crisis high of 150 basis points.

All this suggests distrust between banks remains high and interbank lending beyond a few weeks is only being carried out sporadically on a case by case basis, dealers say.

That's because banks are wary not only of counterparty risk but of their counterparty's counterparty risk.

As the drive to reduce debt, leverage and risk exposure accelerates, this helped fuel the massive selloff in financial share prices this week, leading to an unprecedented wave of consolidation.

Yared at Deutsche Bank and others note that the problems facing financial institutions now are not purely a lack of liquidity but are increasingly doubts about solvency.

"Despite all the central bank measures, the solvency issues remain and it will be difficult to see these measures being able to promote a resurrection in money-market liquidity beyond the very short-term maturities," Dresdner Kleinwort analysts wrote in a note.

"Risk appetite in general is unlikely to benefit more lastingly."

source: 18sep2008