NEW YORK (Reuters) - The Federal Reserve's outstanding central bank liquidity swaps program has shrunk to its lowest level since early December, but if conditions in European unsecured bank funding markets deteriorate, demand for those swaps could rise.
According to the Fed's latest balance sheet update, outstanding dollar liquidity swaps fell to $32 billion in the week ended Wednesday.
But money market players are preparing for a new round of financial stress as concern over euro zone banks' exposure to Spanish and Italian government debt grows and borrowing costs for the two countries rise.
If conditions in European unsecured bank funding markets deteriorate as a result, demand for the Fed's dollar liquidity swaps may rise, said Barclays Capital market analyst Joseph Abate.
Data released Friday showed Spanish banks borrowed a record 316.3 billion euros from the European Central Bank in March because market funding was more expensive.
Italian banks also borrowed 270.1 billion euros, earlier data showed.
The Fed has coordinated with the European Central Bank to provide swap lines to offer dollar liquidity to European banks at times of stress in money markets.
As Spain tries to cut spending without plunging its economy deeper into recession, talk of "contagion risk" has revived and Spanish and Italian yields have been rising since mid-March.
Meanwhile, weekly demand at the ECB's one-week operations has ebbed as replacement demand for maturing operations fades.
Though the ECB's two massive three-year loan operations provided euro funding to the banks, confidence effects, along with reduced overall dollar and euro funding needs, have helped to reduce Libor since the start of the year, Abate said.
LIBOR'S NEXT DIRECTION
London Interbank Offered Rates (Libor) three-month dollar rates were fixed at 0.46615 percent versus 0.46665 percent on Thursday, the British Bankers' Association said.
The three-month dollar Libor/OIS spread stood at 31 basis points versus 32 basis points, according to Reuters data.
But what happens next for Libor depends on whether confidence effects start to wane, Abate said.
And that could happen if the market's focus shifts again to the fundamentals of European sovereign debt.
The upcoming short-term credit review of several European and U.S. banks with global capital markets businesses by Moody's credit rating agencies may not improve sentiment.
"Depending on the willingness of rated money market funds to lend to Tier 2 counterparties following a downgrade, demand for dollar funding through the Fed's central bank dollar liquidity swap program may increase," Abate said.
Meanwhile, recent high fed funds rate levels probably have more to do with the heaviness in repo than with the supply of bank reserves, he said.
"We expect collateral rates to decline this quarter as seasonal bill paydowns build," he added.
General collateral repo softened overnight, noted Roseanne Briggen, market analyst at IFR, a unit of Thomson Reuters.
"Some decent Treasury bill buying appears to be leading general collateral lower," she said.
But the softening in the general collateral rate might prove temporary as the $66 billion in Treasury coupons sold earlier this week settle on Monday, April 16.
(Additional reporting by Marius Zaharia in London; Editing by Andrew Hay)
