Investors are not likely to open their wallets to European banks any time soon despite the efforts of central banks to protect global funding markets from the euro zone debt crisis.
Warnings from rating agencies that they might broadly downgrade euro zone sovereign debt, in which the region's banks have a significant stake, have added to investors' reluctance to lend their dollars.
U.S. interest rate futures, and other indicators of what money markets will charge banks charge for short-term dollar loans factor in a further rise in borrowing costs through the middle of next year.
The expectations of an increase are notable considering the European Central Bank cut interest rates last week to a record low of 1 percent, and the Federal Reserve has kept benchmark dollar rates near zero for three years.
It also means European banks could become increasingly reliant on the ECB for dollar funding, especially while investors remain wary of lending to the region.
"We are doing our best to avoid European bank debt," said Sean Simko, head of fixed income management with SEI Investments in Oaks, Pennsylvania, which manages $179 billion in assets.
Fears persist after last week's summit that European leaders are not doing enough to prevent weaker euro zone nations defaulting, which could trigger another global financial crisis.
Interbank borrowing costs are already approaching their highest levels since June 2009 at the tail end of the global credit crunch. Instead of making short-term loans to European banks, investors have preferred the perceived safety of U.S. Treasury and agency bills which are yielding nil.
Dollar scarcity persists for European banks even after the ECB cut its policy rate and lowered the cost for banks to borrow dollars over the past two weeks.
These ECB moves also have not stopped interbank borrowing costs from rising steadily. The benchmark London interbank offered rate for three-month dollars was fixed at over 0.55 percent on Wednesday — its highest since July 2009. It has more than doubled over the last six months.
"The tail risks have grown and that trend will continue," said Cliff Corso, chief investment officer at Cutwater Asset Management in Armonk, New York, which manages $38 billion.
Eurodollar futures and the forward rates contracts suggest three-month Libor could rise another 10 basis points to 14 basis points by the middle of 2012, which is a substantial rise for banks in this low-interest-rate environment.
Rising open interest on Eurodollar put options also signals some traders are betting interbank borrowing costs would rise into next year, analysts said.
Investor Exodus
In other areas of the short-term funding market, U.S. money market mutual funds are still reducing their investments in euro zone bank debt. Since May, these major providers of dollars have even more than halved their lending to French, German and Dutch banks, which are considered stronger than their Greek, Italian and Spanish counterparts.
In the foreign exchange market, lenders are charging a hefty premium of 1.4 percent for banks to borrow three-month dollars using euro-denominated assets as collateral, up from about 0.25 percent at the end of May.
Thus, European banks are likely to grow more reliant on central banks for dollars to fund trading and operations, or they might choose to reduce trading or sell assets in order to achieve enough of a capital cushion in case the debt crisis worsens.
On Wednesday, a total of 12 banks used the ECB's seven-day dollar swap line, borrowing over $5 billion — around three times the $1.6 billion borrowed at last week's tender.
Stuck
The one hopeful sign might be that, bad as things are, the deterioration in some funding is not accelerating, though the absence of a comprehensive solution to contain the euro zone debt crisis will keep investors on the defensive.
The $2.6 trillion money fund industry has slowed its rollback in euro zone exposure with funds sticking to ultra-short-dated commercial paper, certificates of deposits and repurchase agreements with French, German and Dutch banks.
"Right now there is a core holding that's stabilizing but it's hard to tell how stable it's going to be," said Alex Roever, short-term interest rate strategist at J.P. Morgan [JPM 31.51 
0.22 (+0.7%)] Securities in New York.
0.22 (+0.7%)] Securities in New York. At the end of November, prime money funds which could invest in non-U.S. government securities held $183 billion in euro zone bank debt, down $35 billion in November from October. Their euro zone exposure was down $296 billion since May when the euro zone debt crisis flared up again, according to Roever and his team which analyzed the latest fund data in a report last week.
Despite ECB support, few investors have shown a willingness to lend their dollars to euro zone banks. Instead they have socked their money into U.S. Treasury and agency bills, keeping their interest rates near zero.
"As long as there is no resolution from Europe, you will continue to see the perceived risk-free markets to be well bid," SEI's Simko said.
Copyright 2011 Thomson Reuters.