A key gauge of counterparty risks rose to its highest since the beginning of this year on Tuesday as a potential default in the United States and obstacles to the implementation of a Greek debt deal kept money markets on edge.
The United States is edging closer to a devastating default as Republicans and Democrats struggle to find a deal on raising the debt ceiling. Such a deal is needed by an August 2 deadline, when the country runs out of cash to pay its bills.
Benchmark three-month interbank lending costs for euros rose amid speculation that the euro zone Greek rescue deal could face roadblocks. Among them, some bondholders may choose not to participate in the crucial debt exchange. .
"Over the past couple of days we have had a (re-escalation) of the crisis in the euro zone because the Greek deal isn't seen to be a solution and at the same time we have the debt ceiling saga in the U.S. It all contributes to tension," said Peter Schaffrik, head of European rate strategy at RBC Capital Markets.
The gap between three-month Libor and expectations of central bank rates in the euro zone — a measure of counterparty risk — rose six basis points to 26 bps but was still below 100 bps scaled at the height of the financial crisis two years ago.
The equivalent three-month dollar Libor/OIS spread was steady at 14 basis points.
"There is some nervousness from banks around their ability to borrow or lend at the other side to other counterparties," Chris Huddleston, head of money markets at Investec said.
"That probably is in response to what is going on in the U.S. and the possibility of a downgrade."
Even if the U.S. government agrees a deal by the deadline, rating agencies could still decide it was not enough to curb the deficit in the long term and so downgrade the country's triple-A rated debt — a move that would send shockwaves across financial and money markets.
"Money market funds are the biggest fragility," Lloyds strategist Charles Diebel said.
"They have to hold triple-A paper and that could cause some significant dislocations and could start affecting the funding costs of banks."
GREEK RESOLUTION
Just days after European policymakers toasted a 109 bln euro ($158 bln) bailout aimed at hauling Greece back from the brink of insolvency, speculation some of its hapless bondholders might opt out of a crucial distressed debt exchange is gathering pace. .
There are also worries that the recent move to boost the powers of the European Union's EFSF bailout fund will not be enough to limit contagion and its size would need to be increased to provide assistance for larger economies such as Spain and Italy.
Benchmark interbank funding costs in euro zone money markets rose slightly. The London interbank offered rate for three-month euros rose to 1.56% from 1.558% on Monday.
The dollar equivalent was fixed at 0.2526% from 0.2521% the day prior.
The deterioration of the euro zone crisis has prompted investors to scale back expectations of a further European Central Bank rate hike, with analysts expecting an increase only in mid-2012.
