Money markets short term funding conditions improve

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* Funding conditions for non-U.S. banks improve * Demand ebbs for 3-month part of Fed's liquidity swap lines * Euribor rates hit 16-month low; may fall to record By Ellen Freilich NEW YORK, March 5 A drop in demand for three-month dollars the European Central Bank auctioned to replace money it lent to European banks in December shows non-U.S. banks' access to short-term funding has improved. The ECB made the loans through the Federal Reserve's central bank dollar liquidity swap program, originally started in December 2007 to address severe strains in global short-term dollar funding markets. Demand in the most recent auction for three-month dollars offered by the ECB through the program fell to less than a third of what it was in December as European banks rolled over just $14.5 billion of the $51 billion in maturing loans. "In December, people wanted to make sure they had dollars for year end, but at the replacement auction, they only replaced about $14 billion of it and the total amount outstanding in the Fed's liquidity program will go down as a result," said Joseph Abate, market analyst at Barclays Capital in New York. The development is consistent with Libor rates, which have been easing, and a rise in both the level and average duration of financial commercial paper outstanding. All the trends suggest the "the sense of urgency about getting dollars has abated a little bit," Abate said. That auction of three-month paper occurred against the backdrop of the ECB's longer-term refinancing operation and augurs well for banking system stability. "The LTROs (Long Term Refinancing Operation) were extremely effective against having another Lehman-type freeze up," said James Kee, chief economist at South Texas Money Management in San Antonio, Texas, refering to the Wall Street investment firm whose collapse in 2008 is thought to have played a major role in the global financial crisis. "We're not out of the woods yet, but I'm hoping market moves (on funding concerns) will become less and less severe as markets become more and more convinced that the global financial system is not at risk of collapse," Kee said. Abate said markets are in a multi-year period where fear intensifies and then settles down again. The Fed re-established its central bank dollar liquidity swap program when funding strains re-emerged in May 2010. The swap lines have been extended several times since then. "The Fed doesn't want its central bank liquidity swap lines to become permanent, but it hasn't been able to build the escape velocity to leave this all behind," he said. "Things start to get better and then some other exogenous shock comes and knocks the market back on its heels again. "You need to get confidence restored so people wouldn't hoard liquidity every time something happens," he said. The ability of European banks to fund dollar-denominated assets they own in the private market has improved and interbank lending rates could keep heading lower as a result, said Pierre Ellis, senior economist at Decision Economics. Euro zone interbank lending rates headed toward record low levels on Monday. But liquidity is not the whole story and thus the declines could start to occur more gradually, Ellis said. "The liquidity issue for European banks has been resolved, but now you're looking at the inherent risk of their portfolios which is tied to the outlook for the European economy," he said. Three-month Euribor fixed at a fresh 16-month low of 93.4 basis points on Monday. The rate has fallen every day since Dec. 19, declining by nearly 50 bps in that period. Euribor futures showed the rate was forecast to be 82 bps at the March contract expiry on March 19. In the U.S. short-term debt markets, prospects for lower repo rates into the end of the month and for reduced bill supply heading into the middle of the second quarter partnered with attractive yields to draw buyers to the Treasury's auctions of three-month bills last week and this week, said Thomas Simons, money market economist at Jefferies & Co. Demand for the six-month Treasury bill auction was less fervent.