Dollar funding costs remained elevated in Europe on Thursday as investors fretted about the impact of various proposals to mend the battered financial system and governments' fund raising for stimulus plans.
London interbank offered rates for sterling and euro funds inched lower, however, as the Bank of England cut rates as expected by 50 basis points to a record low of 1.0 percent while the European Central Bank left them unchanged at 2 percent.
The ECB pause was expected after President Jean-Claude Trichet repeatedly said that the bank's next major policy meeting will be in March. Focus on will be on Trichet's news conference later in the day where market participants are looking for signs of how much the bank will cut rates next month as the eurozone economy continues to weaken.
Meanwhile, intensifying fears about governments' fund-raising to meet various fiscal stimulus plans weighed on debt markets, causing yield curves to steepen in the United States, Europe, Australia and elsewhere even as short-term rates remained firm.
Strains were evident in dollar funding, revealing concerns ranging from how a proposed US "bad bank" would affect large banks as well as moves to nationalise the industry. London interbank offered rates for dollar funds were fixed some six basis points up at 1.24 percent, edging closer to a one-month high.
"Investors are a little bit left in the dark about these three proposals that are currently being discussed: bad banks, guaranteeing toxic assets or nationalisation of the banking industry," said Kornelius Purps, fixed income strategist at UniCredit in Munich.
"This uncertainty is probably too high and furthermore interbanking flows are not zero but are certainly still extremely limited," he said. The three-month OIS spread, the spread between interbank rates and overnight-indexed swaps, held around 99 basis points for dollars and pointed to expectations of widening spreads between interbank and policy rates.
"In general it seems as if dollar Libor rates have found a bottom in the area of 95 to 100 basis points above the effective fed fund rate which seems to signal that the general improvement in the money markets which was observable mainly in the rate fixings ... has come to a halt," said Purps. The spread between 10- and 2-year yields in US Treasuries has widened to 195 basis points from 123 at the end of December.
Attempts by the Federal Reserve to keep oiling the world's money markets have failed to bring down dollar funding costs. "The Fed's balance sheet has been shrinking ever since December," said Amy Auster, head of currency and international economics research at ANZ, adding the rise in LIBOR and dollar spreads seemed to be consistent with that "significant shrinkage".
"Everybody was focused on US fiscal stimulus and its impact on the treasury curve but it's hard to find an economy anywhere that isn't experiencing the same thing to one degree or another," Auster said.
The Federal Reserve on Tuesday said it was extending up to October swap lines it had with 13 central banks, through which it provides dollars. It also extended a host of other programmes providing liquidity to US commercial paper and money markets and large firms.
In Australia, yields rose and the curve steepened after the government said on Wednesday it plans to issue between A$22 billion and A$24 billion in debt between now and the end of June. That news about the debt issuance came after the Reserve Bank of Australia cut its overnight rate by 100 basis points to 3.25 percent on Tuesday at the same time that the government announced a second round of spending worth A$42 billion.
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