The cost for banks of swapping euros into dollars has risen since the beginning of April - the latest sign that Spain-fuelled stress in euro zone debt markets is beginning to creep into money markets. Yields on Spanish 10-year government bonds broke above the important 6 percent mark this week, with the country's Treasury poised to test market appetite for its bonds on Thursday.
Strong demand at a Spanish bill auction on Tuesday offered some respite for peripheral debt in secondary markets but a rise in short-term borrowing costs underscored the challenges still facing the highly indebted country. Its austerity drive risks pushing the euro zone's fourth largest economy deeper into recession - a plight that could be exacerbated if yields rise to prohibitive levels.
Such concerns have started to seep through into money markets as the impact of one trillion euros worth of cheap European Central Bank funding injected into the financial system in December and February also start to fade. The euro/dollar one-year cross currency basis swap, which widens when lenders charge more for swapping euro interest payments on an underlying asset into dollars, was at -59 basis points, not far from -60 bps hit in the previous session - its widest in around six weeks.
"It's Spain, as simple as that," said a trader, explaining the move. "What happens when there is a little bit of stress in the market - and it has been Spain for the last two weeks - (is that) the cross currency goes up because it's basically harder to get dollars."
Meanwhile, measures of counterparty risk in the interbank market have also stabilised since the beginning of April. The spread between three-month euro Libor rates and overnight indexed swap rates last stood at 31 bps, little changed from around 30 bps at the beginning of April.
In March, that same spread fell by more than 20 bps. "I guess it's a case of how much juice there was to be extracted from these ECB operations," Simon Smith, chief economist at FX Pro said. The Libor/OIS spread could nudge back towards 40 basis points over the next five to six weeks, Smith said. That would be less than half the levels reached in December of last year.