US Money Markets--Another Channel of Contagion

New earlier this month that Moody's was placing 3 French banks on review for a possible downgrade renewed investors focus on the potential contagion through US money markets. It appears that European banks secured dollar funding through issuance of commercial paper and other short-term instruments that US money market funds purchase.

Fitch estimates that 10 of the top 15 issuers of such short-term paper are European banks and Moody's estimates that of over half of that is accounted for by Frenchbanks. There has been a net withdrawal from US money market funds and it appears that the funds have moved to strictly US Treasury or US high grade money market funds. This, coupled with new regulations/fees, and a reduction of bill offerings from the Treasury as it approaches its debt-ceiling, has weighed on US bill yields. The 4-week bill yield appears negative and the 3-month bill is at about 1 bp annualized yield, for example.

In addition, a large Spanish bank is reportedly experiencing difficulty in recent weeks funding itself in the US CP market. The amounts involved seem relatively modest compared to the bank's balance sheet, but the tension is evident. Moody's warning on Italian banks also pushes in the same direction.

These money market developments are consistent with another dimension to another issue we have discussed recently--the pressure evident in the basis swap (cost of swapping euros for dollars by European banks). These developments emanate from concerns about counter-party risk. This is consistent with market talk that some institutions are reducing some credit lines/exposures to European banks. Banks appear to be responding by hedging/securing funding through yen swaps. Note that Japanese 3-month T-bill yield of 9 bp annualized is the lowest in nearly 5 years.

In addition, the European banks may be more aggressive in borrowing from the ECB in its weekly facility. Last week's operation saw a larger than expected take down of over 50 bln euros. This week's operation may offer more insight.