Money Markets Still Under Stress

The Financial Times reports that rates in the interbank money market are well above normal levels, indicating considerable lender worry, and that the effect of the announcement of the SIV rescue plan appears to have more than offset the anticipation of further interest rate reductions by the Fed.

From the Financial Times:

The cost of funds in the strained interbank money markets remained abnormally high yesterday in spite of growing expectations of an interest rate cut by the US Federal Reserve this month.

While the three-month London interbank offered rate (Libor) – an important borrowing benchmark for financial groups – in the dollar, sterling and euro markets have come down from their peaks in recent weeks, lending rates in all three are still stubbornly high compared with historical levels.

A key measure of these difficult lending conditions is the movement in the three-month overnight index swap sector. The OIS – which tracks the relationship between an expected three-month Fed funds rate and three-month Libor – is elevated at 60 basis points. This swap has abated from a peak of 95bp prior to last month’s rate cut by the Fed. But under normal conditions, the swap should trade around 8bp.

Yesterday, in the dollar market, overnight Libor was set at 4.81 per cent, just above the Fed funds rate of 4.75 per cent. The three-month level of 5.084 per cent was above both the two-month (4.965 per cent) and four-month (5.04 per cent) levels. But with interest rate futures pricing in the strong likelihood of a further Fed rate cut either at the end of this month or in December, dollar Libor has further room to fall before it attains normal levels, traders say.

One reason for the continued stress in the money markets, some traders say, is concern about the proposed $100bn superfund, which is meant to revive the asset-backed commercial paper market – an important source of short-term funding for financial groups.

With the major money centre banks such as Citigroup, Bank of America and JPMorgan behind the plan, investors in the interbank market remain cautious.

Specific details of the plan are shrouded in uncertainty. One trader said: “The market is linking Libor and the super Siv fund, and how that plays out will determine how quickly Libor normalises.”

The “turn of the year” effect is also fuelling the reluctance of banks to lend to each other in maturities that extend beyond the end of the year.

Don Smith, bond economist at ICAP, said: “Institutions will generally charge a premium for lending money if the period extends beyond the turn of the year as this is when they would prefer to have access to this liquidity.”

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