Bank-to-bank dollar funding costs fell again to historic lows on Tuesday, reflecting a gradual return in confidence in money markets that analysts also caution still has some way to go. Money market participants took heart after US stress tests on major banks revealed no nasty surprises, adding to the slow healing in the financial system.
Some market participants said plans by the European Union to carry out similar tests on its banking system could also foster confidence by weeding out problems in the sector. According to EU sources, the EU will carry out the stress tests to determine its banking system's resilience to the economic downturn and find out if it is adequately capitalised by September.
The three-month dollar London interbank offered rate (Libor) marked a record low of 0.906 percent, while equivalent euro and sterling rates also touched new lows of 1.28688 percent and 1.4006 percent respectively. Overnight euro Libor, however, fixed 31 basis points up at 0.7250 percent after the European Central Bank said it planned to drain overnight funds in a fine-tuning operation on the final day of the reserve maintenance period.
"The perception of risk within the banking system has improved. That does not yet mean that we will see vivid turnover in the three-month area in the term interbank lending market," said Kornelius Purps, an interest rate strategist at UniCredit in Frankfurt.
"Central bank action and lately the apparently successful stress tests have improved sentiment further. We should be cautious and patient for existing barriers to trade to be removed," he said. Other market participants also sounded a note of caution saying a widening in the bid and offer spreads for dollar Libor showed lending was still very name selective and money market flows were subdued below those seen before the financial market crisis erupted in July 2007.
"It's been a familiar story that lending up to three months is doing fine but lending longer is becoming problematic, there's no supply there," said Kenneth Broux, a market economist at Lloyds TSB in London. While the slow thaw in money markets has seen the premium that Libor rates trade over a risk-free benchmark, the Overnight Index Swap rate (OIS), easing from historic highs hit in the aftermath of the Lehman Brothers' implosion in mid-September, they still remain elevated versus to their pre-crisis levels.
Three-month dollar/OIS spread tightened by two basis points to 72 basis points on Tuesday, its narrowest since late July. Still, that spread traded consistently at around 10 basis points before the financial crisis erupted in July 2007. Traders said they expected credit spreads would not tighten any further, unless there was major news suggesting further strengthening of the financial sector or the economic situation.
Since the collapse of Lehman Brothers late last year, central banks have been pivotal in providing banks with massive short-term liquidity as the money market froze up. The equivalent sterling spread held steady around 101 basis points while the euro spread edged out two basis points to 62 basis points.
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