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U.S. Swap Spread to Widen on European Crisis, Nomura Says

Aug. 3 (Bloomberg) -- Nomura Holdings Inc. advised betting that U.S. two-year interest-rate swap spreads will widen on renewed concern Europe’s sovereign debt crisis will increase demand for dollar-denominated funding in the region.

The gap between two-year swaps and comparable maturity Treasury note yields will widen from 24.7 basis points to an initial target of 33 basis points and then to 40 basis points, George Goncalves and Marcus Phua, strategists at Nomura, said in a note yesterday. They advised setting a stop-loss, or a pre-set level to exit the trade, if the gap narrows to 21 basis points.

Dollar London interbank offered rate, or what London-based banks say they pay for three-month loans in dollars, rose today to the highest level since May. The swap spread is based in part on expectations for dollar Libor and is used as a gauge of investor perceptions of credit risk in the banking sector.

“Markets are in a risk-reduction mode,” Goncalves, head of interest-rate strategy at Nomura, said in a telephone interview. “The market has been televising since the recent EU summit that there has to be a bigger plan in place to address the real crux of the problem, European banks and their capital base and funding needs. The overall health of the European banking system is tied to the sovereign issue.”

Italian and Spanish bond yields rose this month as the latest European Union and International Monetary Fund rescue deal for Greece, struck two weeks ago, failed to reassure investors the contagion from the debt crisis will be contained.

Libor Rises

The EU bailout includes contributions from banks and other private bondholders through a series of exchanges and buybacks that will cut the debt load. The agreement also consists of 109 billion euros ($155 billion) from governments and the International Monetary Fund.

Three-month dollar Libor was set today at 0.26828 percent, up from 0.26444 percent yesterday, according to data from the British Bankers’ Association. The dollar Libor-OIS spread, a gauge of banks’ reluctance to lend, was little changed at 14.8 basis points today, compared with 13 basis points on July 29.

The June completion of the Federal Reserve’s $600 billion Treasury purchase program, which helped lift bank reserves to over $1.6 trillion, raises the probability of Libor rising and swap spreads widening, Goncalves said.

Swap rates are usually higher than Treasury yields in part because the floating payments are based on interest rates that contain credit risk. Swap rates serve as benchmarks for investors in many types of debt, including mortgage-backed and auto-loan securities.

FRA/OIS Spreads

“Spot Libor may not actually prove to move as much as swaps spreads may widen but it’s more so about the markets’ expectations of frictions in the interbank market,” Goncalves said. “We may see that in the forward spreads -- which may widen even if spot Libor rates aren’t moving that fast.”

Predictions for the dollar Libor-OIS spread at the end of the year, based on contracts trading in the forwards market, or so-called FRA/OIS spreads, are at 35.29 basis points by December, based on Tullett Prebon Plc data. The spread has widened from about 22 basis points on June 30.

Overnight index swaps, or OIS, give traders forecasts of what the Federal Reserve’s overnight-lending effective rate will average for the term of the swap. The central bank’s target rate has held in a range of zero to 0.25 percent since December 2008.

To contact the reporter on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net

To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net

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