Money markets rate swaps show high central bank expectations

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U.S. interest rate swaps have rallied sharply this month even as yields on risky European debt, including Spain's bonds, increased, a move that some fear may reflect overconfidence in the ability of central banks to stem contagion from Europe's debt woes. Two-year interest swaps, which are seen as a proxy for bank credit risk, tightened to 22.50 basis points on Monday, and are down from 38 basis points at the beginning of the month. The move since June 1 reflects a breakdown of the swaps' previously strong correlation to Spanish, Italian and other peripheral European debt spreads, which have been worsening. The rally in the swaps may reflect high market confidence in central bank programs to ease pressures on the region's banks, said Ralph Axel, an interest rate strategist at Bank of America in New York."The market more and more believes that central banks will do whatever is necessary, and not just that they will act but that they can effectively prevent any kind of funding or liquidity problems," Axel said."As soon as that confidence leaves, it could be a major swap widening event, though I don't know if that will happen," he added.

Analysts at Barclays Capital noted that the correlation between Spain's sovereign debt and other assets, including world stock markets, has also broken down of late, calling the effect "puzzling.""We very much doubt that it will persist if market pressures on Spain continue to mount in the weeks and months ahead," Michael Gavin, head of global macro and emerging market strategy said in a report on Monday. Spain formally requested European aid for its indebted banks on Monday, but the lack of details rekindled investor doubts over the financial sector, hours before Moody's was expected to cut the ratings of all Spanish lenders.

CONFIDENCE COULD WORSEN Bank of America's Axel recommends entering into trades that would benefit from two-year swap spreads widening from around 20 basis points, noting these levels are near their tight levels historically and on the expectation they could widen on a renewed crisis of confidence.

"There could be a combination of things like fears that bank losses will be uncontrollable, combined with political arguing or separation, a feeling that central banks have lost control of the situation," Axel said. Central banks have eased funding concerns by offering cheap loan and swaps programs to banks, as well as various bond purchase programs, and as economic conditions worsen globally there are high expectations of further assistance. But many see the measures as stop gap, and say that more definitive solutions are needed from political leaders in the region. The Bank for International Settlements, a global forum for central banks, said on Sunday that leaders in the euro zone should create a banking union and warned that central banks are limited in their ability to contain the crisis."Central banks are being cornered into prolonging monetary stimulus as governments drag their feet and adjustment is delayed," the BIS said, adding that if the root causes of financial and economic weakness are not addressed, central banks will come under pressure to do more than they can actually deliver. German Chancellor Angela Merkel said on Monday that shared debt liability within the euro zone was "economically wrong" and "counterproductive," ahead of a highly anticipated two-date summit in Brussels starting on Thursday.