October 18, 2018 / 9:37 PM / 25 days ago

UPDATE 1-Money markets show strain with more Federal Reserve rate rises ahead

* LIBOR posts biggest one-day rise since late May

* Traders dumped December Eurodollar futures contracts

* Fed funds/IOER spread contracts to tightest ever at 1 bps (Adds background, quotes, graphics)

By Richard Leong

NEW YORK, Oct 18 (Reuters) - Several measures of U.S. short-term borrowing costs rose sharply on Thursday, suggesting money markets may see more volatility as the Federal Reserve signals interest rates have further to climb in a robust economy.

The sudden jump in the benchmark London interbank offered rate, or LIBOR, and a price drop in a futures contract connected to it caught many market participants by surprise.

“What a mess at the front end of the rates market today,” said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott in Philadelphia. “It may be related to the plumbing in financial markets that is not readily apparent.”

The three-month LIBOR rate, a benchmark for $200 trillion worth of U.S. financial products, rose by nearly 2 basis points, its largest daily rise since May. It hit 2.469 percent, its highest level since October 2008.

Prices on December Eurodollar futures, which gauge traders’ expectations on LIBOR, posted the steepest one-day drop among all traded contracts. Thursday’s trading volume for this contract totaled close to 800,000, which was the most for second front-month contract since Donald Trump’s U.S. presidential win in November 2016.

FALLING BANK RESERVES

Another market indicator that caught some traders’ attention was the spread between the federal funds rate and interest on excess reserves which is seen by some analysts as an indicator on how effectively the Fed is controlling short-term rates.

Excess bank reserves have been falling since the Fed began paring its balance sheet which peaked at $4.5 trillion in October 2017.

The federal funds rate is what U.S. banks charge each other to borrow excess reserves overnight.

The fed funds rate averaged 2.19 percent on Wednesday, narrowing its spread to IOER to 0.01 percentage point. This marked the slimmest margin since IOER was introduced in 2008, data from the New York Fed released on Thursday showed.

Some analysts have raised concerns the fed funds rate may break above IOER, stoking worries the Fed would lose its grip on its main policy tool.

The Fed has downplayed this risk. Some Fed officials have attributed the rise in money market rates to the surge in U.S. Treasury bill supply, not the shrinking Fed balance sheet and the decline in bank reserves.

The Fed’s minutes on its Sept. 25-26 policy meeting, released on Wednesday, described last month’s narrowing of the IOER and fed funds spread as sharp but temporary.

“We agree with the Fed that rising bill supply is pushing up market interest rates,” said Michael Feroli, an economist at J.P. Morgan. “There’s little sign that it’s reserve scarcity is the culprit.”

Reporting by Richard Leong; editing by Clive McKeef

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