Libor reflects money market freeze; policy response eyed

LONDON (Reuters) - A slight fall in London interbank offered rates for three-month dollars on Monday offered a faint glimmer of hope that money market strains might be easing, but conditions remained poor and lending virtually non-existent across all maturities.

Three-month dollar Libor fell for the first time in six sessions and by the largest amount in five months. But the closely-watched spreads over anticipated policy interest rates, which reflect the degree of money market stress, hit fresh highs.

Interbank lending rates for overnight dollars and euros also rose, despite another round of dollar liquidity injections into the banking system from the Bank of England and European Central Bank.

Demand for overnight dollars remained strong. The combined BoE and ECB injection of $60 billion of overnight funds into the system was oversubscribed, particularly from euro zone financial institutions.

Funding conditions over periods of one and three months were as tough on Monday as at any time during the crisis, even though the $700 billion U.S. financial rescue package passed into law on Friday.

The premium for borrowing three-month dollar and euro Libor funds over anticipated central bank rates, as measured by average Overnight Index Swaps, hit new highs.

These developments followed another weekend of frenetic activity in European political and banking circles as authorities and officials across the continent scrambled to alleviate the deepening financial crisis.

"We expect spreads to remain elevated as long as governments fail to provide explicit guarantees for bank liabilities, which are the problem in this crisis," wrote BNP Paribas strategists in a note.

"In addition, one should be ready for more coordinated action by central banks in the coming days, via additional liquidity operations and emergency rate cuts."

Overnight dollar Libor on Monday was fixed at 2.36875 percent, compared with Friday's 1.99625 percent.

Friday levels were remarkable because they were below the Federal Reserve's official 2 percent target rate, whereas bank-to-bank lending is usually at a premium.

Three-month dollar Libor was fixed a little lower at 4.28875 percent, but three-month euro Libor rose to a new record high of 5.33750 percent.

The three-month Libor/OIS spreads for dollars and euros hit record peaks of around 292 basis points and 145 basis points, respectively.

GLOBAL CRISIS

Libor deposit rates are purely indicative levels of what rates banks expect to lend to each other at, not necessarily levels at which they are lending or borrowing. In the current extraordinary market tension, they've been especially volatile.

But trillions of dollars of financial, corporate and household borrowing is referenced to Libor.

"There are clear signs of top-rated industrial companies no longer having access to credit markets. There is a complete loss of trust in counterparty," strategists at Credit Suisse wrote in a note on Monday.

"We need a systematic, not an ad hoc approach, in Europe. We need immediately to take at least half a percentage point off rates and to see the yield curve steepen. The crisis is as much European as U.S.," they added.

Last week, the ECB left its benchmark rate at 4.25 percent but highlighted the risk to the European economy from the financial crisis. Financial markets expect it to cut rates by its next scheduled policy meeting in November.

The market has also moved to price in fully at least a 50 basis-point cut in the Federal Reserve's 2 percent funds rate at its policy meeting later this month.

Over the weekend leaders of Europe's four biggest economies -- Germany, France, Britain and Italy -- decided against a coordinated bank bailout, while vowing to stabilize markets.

Germany offered on Sunday a blanket bank deposit guarantee as it clinched a deal to rescue lender Hypo Real Estate , while officials across the globe scrambled to contain the fallout from the deepest financial crisis since the 1930s.

Denmark also guaranteed savers' deposits, Sweden expanded its deposit guarantees, a UK Treasury official said Britain is prepared to take "radical" action if needed to stabilize the financial system, and Iceland's government scrambled to avert a financial meltdown.

In Asia, the Bank of Japan said on Monday it offered to lend 1 trillion yen against pooled collateral in an auction to inject liquidity into the market.

South Korea's finance minister said the government would use the official foreign reserves to help banks which faced difficulties in securing enough foreign-currency liquidity.

An index of European bank stocks was last down 6.25 percent on Monday, also indicating how the interbank market remains gummed up. "It's completely frozen. We're not trading. It's only positioning," said a money markets trader in Dublin.