EXPLAINER-U.S. bank funding costs: Five pressure points for markets

By Dhara Ranasinghe and Saikat Chatterjee

LONDON, March 23 (Reuters) - A surge in U.S. short-term bankfunding costs, traditionally a key gauge of stress, has grabbedthe attention of investors who are trying to assess whether ithas wider ramifications for international markets.

The three-month London interbank offered rate (Libor)has risen rapidly, with its premium above theovernight index swap (OIS) hitting 58 basis pointson Friday, its highest since May 2009.

Analysts say the rise largely reflects increased U.S.Treasury bill issuance and repatriation of funds, with a limitedimpact so far on other markets.

The spread was a leading indicator of previous dollarfunding crises in 2008 and 2011-12, and some analysts believe itcould again have significant knock-on effects, particularly whencentral banks are winding down crisis-era stimulus policies.

Here are five pressure points that investors are watching tosee if the surge escalates into a global dollar funding crisis.

1/ Non-U.S. dollar funding costs

A blowout in the U.S. Libor-OIS spread hasn't beenaccompanied by a widening in equivalent spreads in othercurrencies such as euros, Japanese yen or sterling.

Investors say this shows there is no widespread rush tosecure cheap funds elsewhere.

"If this was a crisis sign in the market, then we would seeother spreads blow out as well at the same time, which we saw inthe last financial crisis and in the euro zone crisis," TimForster, portfolio manager at Fidelity International, said.

Andrew Milligan at Aberdeen Standard Investments, said onevulnerability could be emerging markets that borrow in dollarsor have currencies pegged to the dollar.

The Hong Kong dollar is poised to hit the lower endof its dollar trading band for the first time in more than threedecades.

2/ Currency hedges

One of the first places where a rush for dollar fundingescalates is in the arcane but deeply liquid world of currencybasis swaps, used by institutional investors to hedge theirforeign bond investments.

During the 2008 financial crisis and the 2011-2012 euro zonedebt crisis, banks, especially non-U.S. institutions that foundthemselves shut out of the U.S. interbank markets, tapped thecurrency swaps markets in euros and yen and exchanged them.

But this time around, funding pressures are absent. Ifanything, these markets are indicating a surfeit of dollars withcurrency swaps in yen and euros at five-year highs.

This is due to increased regulations forcing global banks tokeep more reserves and because banks anticipated the increasedissuance of U.S. Treasury bills and secured dollars early.

3/ Corporates

Instead of seeking dollars in U.S. money markets to fundtheir international operations, European corporates could issuemore dollar-denominated debt at home.

With Libor, a reference rate for $200 trillion worth ofdollar-denominated financial products, at its highest since2008, analysts say a pick-up in dollar-denominated bond issuanceby European corporates, especially banks, may follow.

This week has seen HSBC, Europe's largest bank, andGermany's NRW Bank issue dollar-denominated debt.

A surge in outstanding U.S. Treasury bills to a record $2.3trillion has also put upward pressure on short-dated U.S. bondyields - something analysts say is crowding out money marketfunding and forcing issuers of commercial paper to offer higherspreads amid generally rising rates.

This impacts the Libor fixing as commercial paper rates aretaken into consideration by the panel of banks for Libor quotes.

"If the Libor/OIS spread stays as it is, we will see quite abig move higher in the dollar index and then dollar borrowingfor foreign investors becomes more expensive," Mike Riddell, afund manager with Allianz Global Investors, said.

4/ Central banks

One concern is that higher U.S. borrowing costs, if theypersist, could tighten financial conditions and potentiallyreduce how aggressively the Federal Reserve raisesrates.

The same could be true for the euro area as tighter U.S.financial conditions spill over into Europe, possibly delayingthe European Central Bank's timeline to exit stimulus. A firmeuro has already contributed to tightening euro zone financialconditions faster than the ECB would like.

"The longer it goes on, the more pronounced the effects aregoing to be," said Charlie Diebel, head of rates at AvivaInvestors. "It complicates the efforts of policymakers becausein Europe we still have QE (quantitative easing), but we havesome sort of tightening coming at the same time."

Indeed, Commerzbank says the sharp rise in dollar Liborrates could be seen as one additional rate hike since the Fed'sDecember meeting.

5/ U.S. dollar

Citibank says the dollar-Libor/OIS spread has in recentyears proved a good leading indicator for the dollar index,which measures the greenback's performance against other majorcurrencies. Wider spreads tend to lead to a strongerdollar, with a three-month timelag.

"We are still forecasting dollar weakness on fundamentalgrounds – together with almost everyone else," the bank said."But if dollar liquidity tightening does lead to a strongerdollar, all of these processes have the ability in principle torun in reverse."

(Reporting by Saikat Chatterjee and Dhara Ranasinghe;Additional reporting by Sujata Rao and Abhinav Ramnarayan;graphics by Ritvik Carvalho and Saikat Chatterjee; Editing byAlexander Smith)