Forget the election result: the cold reality come Monday morning will be interest rates and the gradual freezing of credit markets around the world.

The Reserve Bank Wednesday pumped more money into the interbank money market than it has since the dark days of the first credit crunch back in mid-September.

More than $4.7 billion was made available to the market via repurchase agreements of $1.44 billion to cover a $1 billion deficit on the day, and through $3.3 billion being left in the exchange settlement account the banks keep at the Reserve Bank. That was the largest amount left in the account since around September 19.

Yesterday the RBA covered a $2.4 billion deficit through $1.845 billion in repurchase deals, it bought $283 million in state and semi-government bonds and bought $400 million of residential backed mortgage securities (RMABS). The two tranches of $200 million deal in, one for 85 days, the other for 140 days.

That was the largest amount of RMBS bought by the bank since it changed the rules in August to give itself the freedom to deal in these riskier mortgage-related securities.

The bank had been testing the water with occasional smaller purchases and the fact that it bought such a large volume is a sign of hoe strained conditions are in the interbank market at the moment: whoever did the deal with the RBA didn’t have enough bank bills and other tradeable securities available to do a normal repurchase deal with the central bank.

Short term interest rates on bank bills continue to either edge towards a record 7% for 30 day paper, climb past 7.10% for 90 day paper and are around 7.30% for 180 day paper.

Merrill Lynch, the investment bank, remarked in its overnight note to clients that:

Credit spreads have again blown out across the spectrum. Compared with the initial August movements, the Australian banks look better on the short end (cash-90 under 50bp), whilst the Australian 5 year swap spread approaching 100bp (or 1% over the equivalent bond rate) is far worse than the 70bp reached previously.

Corporate spreads have also moved wider than in August given downward revisions to the global growth outlook.

That means at the short end, up to 90 day bank bills, the margin the banks are paying over the RBA cash rate is less than half a per cent, which is better than it was in August and a sign that the banks are still dealing. But further out the margin is rising. At the five year area very few deals would be done with the bond market 1% below what the banks are charging each other as measured by the swap rate. (That’s when you borrow in one currency and swap it back into Aussie dollars).

In the past two days yields on Government bonds in Asia and the US have dropped as stockmarkets fall and worries about subprime mortgage losses escalate. And the past day or so has seen some dramatic developments in European money markets.

The continent’s $US2.8 trillion bond market that helps refinance mortgages, has been shut down until Monday because buy/sell dealing spreads had widened to where the market has stopped functioning. Over $US2 billion in bond issues by three banks were called off because the market for what are called “covered bonds” froze.

France’s biggest bond insurer, CIFG Guaranty will be bailed out in a $US1.5 billion deal that will see it taken over by two French banks. And bond yields in the US and Europe have started moving apart while interest rates on three month deposits in China and Korea have crashed to just 1%, a drop 3% in less than a week.

The Hong Kong market is off nearly 20% from its peak because moves to allow direct Chinese investment in the market have been abandoned for the time being: Tokyo is off 21% from its peak in February and after a 4.5% drop yesterday, China’s stockmarkets are down nearly 20% from their peak in October.

In a rare move, the European Covered Bond Council said it was suspending trading of mortgage-linked bonds in the inter-bank-market owing to the “undue over-acceleration in the widening of spreads”.

European interest rates are now 1%-2% above comparable US rates, with Government bond yields in Europe at a premium. The commercially sensitive London Interbank Offered Rate which sets benchmarks for borrowings around the world in various currencies, is now trading at premium of 1.5% or more to the comparable US treasury bill yield. That premium gap hasn’t been seen since the 1987 crash, according to some traders.

And European bond markets saw some crazy moves in the past 24 hours as yields on Italian, Spanish, Belgium and Greek Government bonds all rose compared to the benchmark German bonds.

Yields on these and other sovereign bonds (Such as Irish and Solvenian Government securities) have traded at premiums above the comparable German bonds, with the Italian Government bond premium averaging 0.20% in recent years. Yesterday the premium for Italian bonds jumped to 0.40%, and for Belgium to around 0.29% in dramatic moves.

Traders say Belgium is now seen as possibly splitting along racial ground in the near future, while Italy, greece and even Spain are being priced as bigger credit risks than Germany because of the pressures the rising euro is imposing in those countries.

Germany is seen as the best credit risk in euroland and everyone else is being forced to pay more as a result.

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Peter Fray
Peter Fray
Editor-in-chief of Crikey
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