Money market stress seen lingering until 2010

By Kirsten Donovan - Analysis

LONDON (Reuters) - Money market stress may start to ease early next year as the raft of government and central bank actions gain traction but it could take at least another year before interbank lending is fully functional.

Since the collapse of Lehman Brothers in September, banks' confidence in one another has been shattered and interbank lending -- the lifeblood of the financial system -- has halted.

Despite the best efforts of governments and central bankers to kick-start the system with coordinated interest rate cuts and a host of other steps, the premium banks must pay to borrow three-month funds has remained high by historical standards.

But one perception of banks' risk appetite and willingness to lend to each other -- so-called forward Libor/OIS spreads -- are starting to show signs of easing once the volatile year-and period passes.

The spread expresses the expected future three-month premium based on London interbank offered rates (Libor) over anticipated central bank rates, or Overnight Index Swap (OIS) rates -- a key measure of financial market stress.

Market pricing shows the anticipated three-month Libor/OIS spread in dollars falling to around 185 basis points in December and 106 bps in March, from the current spot level of 352 basis points.

Similarly euro spreads are seen narrowing to around 58 basis points by March from a current 178 basis points and sterling to around 80 basis points from around 212 bps, according to data from BNP Paribas.

But strategists say a real normalisation may not be seen until at least the beginning of 2010 -- where forward dollar and euro Libor/OIS spreads are around 40 basis points the sterling spread around 60 basis points.