Money market strains ease as policy kicks in

London interbank offered rates (Libor) in all three currencies for lending overnight to a year were again fixed lower at the British Bankers Association's daily fix.

The steepest Libor declines were in the one-week horizon, where major central banks in Europe pumped in hefty amounts of liquidity on Wednesday, and overnight euro Libor was fixed below the European Central Bank's official policy rate.

Other measures of money market dislocation like the premium for Libor borrowing over anticipated central bank rates, known as Libor/OIS spreads, also eased as liquidity flowed into the banking system and confidence slowly returned.

‘Following the release of national 'bailout' plans from UK, Germany, France, U.S. and others, there are early signs that the severe money-market tension of the last month may be easing,’ said Meyrick Chapman, strategist at UBS.

‘We think the easing will continue.’

For more on the latest efforts from governments and monetary authorities across the world to end financial crisis, see.

Chapman pointed to increased activity in the European commercial paper market, particularly in the financial sector, as green shoots of recovery in money markets.

He also said the increasing divergence in rates posted by banks at the daily fixings this week should be welcomed as a sign competition between banks is returning.

‘European banks are now awash with cash,’ said Vincent Chaigneau,’ head of strategy at Societe Generale.

Overnight euro Libor was fixed lower at 3.73625 percent on Wednesday, below the ECB's 3.75 percent target rate.

One-week dollar Libor was fixed a quarter of a percentage point lower at 3.82500 percent. Coming on the back of Tuesday's 50-basis point fall, one-week dollar Libor chalked up its steepest two-day decline since January.

For more on Wednesday's Libor fixes and spreads, see.

Spreads narrow

On the central bank front, the ECB, Bank of England and Swiss National Bank offered banks billions of overnight and one-week dollar funds, while Japan spearheaded Asian moves by procuring an unlimited currency swap line from the Federal Reserve.

The ECB lent banks $170.925 billion for seven days in its first ever auction of unlimited dollar funds and $100 billion in overnight funds. For more, see and.

The BoE auctioned $10 billion in overnight funds, tendered bids for one-week dollars and drained $3.7 billion in overnight funds form the system, less than its $5 billion target.

In an indication the unprecedented pledges from governments around the world to support the banking system and money markets are beginning to be felt, so-called forward ‘Libor/OIS’ spreads continued to fall.

These spreads measure the premium paid for Libor borrowing over anticipated central bank policy rates measured by Overnight Index Swaps, and are seen as a key measure of broader financial market dislocation.

Forward Libor/OIS spreads for December 2009 in dollars, euros and sterling are now back below levels just before the demise of U.S. investment bank Lehman Brothers a month ago unleashed the most serious phase of the global financial crisis, said Laurence Mutkin, head of rates strategy at Morgan Stanley.

‘There's still a lot of uncertainty about how all these bailouts and rescues are going to work out. But if they're going to work, this is how it will look,’ Mutkin said, adding that he expects interest rate swap spreads to fall sharply too.

Swaps measure the cost of exchanging fixed and floating cash flows and are designed to help firms and banks offset interest rate risk or uncertainty. The swap spread measures this rate over and above the borrowing costs of top-rated, ‘risk free’ governments.

A contracting swap spread reflects reduced financial stress because it signals both falling demand from borrowers to hedge rising interest costs and also lower aversion of lenders to lend to anything but the most creditworthy borrowers.

Ten-year euro swap spreads narrowed to 54 basis points on Wednesday, around 30 basis points below levels seen in the immediate aftermath of Lehman's collapse.

But even though governments have pledged to guarantee large swathes of interbank lending, banks remain wary of lending for periods longer than a week, which is keeping 'term' funding costs like three-month rates relatively high.

Libor rates are only indicative prices of where banks are lending to each other, not necessarily the levels at which lending is actually being carried out.