August 10, 2011 / 7:48 PM / 6 years ago

Money markets: FX market shows banks scrambling for dollars

NEW YORK (Reuters) - European banks are relying more on the foreign exchange market to obtain dollar funding, as fewer investors are buying their U.S. short-term debt due to fears that the region’s debt crisis could spin out of control.

In the euro/dollar cross-currency market, where a bank can swap euro interest payments with a lender for dollars, the three-month cross rate spiked to minus 84 basis points, the highest since the end of 2008 during the global financial crisis.

This rate has doubled in three weeks, but it was still far below the peak of minus 300 basis points seen in the fourth quarter of 2008 when money markets froze after Lehman Brothers collapsed.

Back in early May, it stood at about 18 basis points.

“It is the biggest sign that significant stress has emerged in the dollar funding market in Europe,” said Amrut Nashikkar, analyst at Barclays Capital in New York.

U.S. money market mutual funds reduced their holdings of securities issued by European banks in July, spurred by the region’s debt problems, according to J.P. Morgan Securities.

Bank borrowing costs for dollars in other areas of the credit market have been climbing but increases have been modest.

Most European banks with U.S. operations have a huge pile of dollar bank reserves with the U.S. Federal Reserve.

Also, the Fed, the European Central Bank and other major central banks have swap lines for overseas banks to access dollar funding in case of emergency.

These factors should prevent the debt predicament in Europe from spiraling into the kind of credit crisis seen three years ago.

“The big difference between now and ‘08 is that banks do have a lot of liquidity. I think there will be some tension but I don’t think there will be a blow-up like happened in ‘08,” said Frederic Gourtay, head of U.S. dollar swaps trading at RBC Capital Markets in New York.

Morgan Stanley strategists expect the euro/dollar basis swap to be capped around minus 100 basis points, which is what the ECB charges on its dollar swap line offered weekly but has so far seen no take-up from banks because of the stigma attached.

Still, investors are on edge.

London interbank offered rates for three-month dollars rose to a fresh four-month high of 0.28061 percent despite the Fed’s pledge to keep interest rates near zero for at least two more years.

“There will probably be some pressure on Libor and money market funding,” said RBC’s Gourtay, who expects Libor may increase to around 35 to 40 basis points by September.

Equivalent euro rates fixed lower at 1.50188 percent, from 1.51188 percent, on increased excess liquidity in the system after the ECB offered banks more unlimited cash to ease strains in financial markets.

Additional reporting by Emelia Sithole-Matarise in London; Editing by James Dalgleish

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