Credit market conditions tightened on Tuesday sending euro money market overnight rates to a three week high as worries about the economic cost of the credit crunch spooked lenders.
A few borrowers tested the waters with bond issues but most investors sat tight before crucial U.S. home sales and consumer confidence data with their implications for the chances of another U.S. rate cut.
International Monetary Fund Managing Director Rodrigo Rato gave a relatively optimistic assessment of market conditions, in contrast to more gloomy comments on Monday which dealers said were partly responsible for the markets' latest bout of angst.
"We have to recognise that the evolution of recent days is moving towards normalisation. Credit markets are easing," he told a news conference in Moscow.
He added that while impact of the crisis would be serious for global growth, it would be modest. On Monday, Rato warned the credit crunch would have its worst impact next year and still had some time to run.
Many banks were still feeling the effects of the credit squeeze and were scrambling for cash.
Demand from ECB High
The overnight euro London Interbank Offered rate (Libor) was fixed at 4.24750%, up from 4.10125% on Monday and the highest since September 5.
Demand was startlingly high at the weekly refinancing by the European Central Bank on Tuesday. The average rate moved up to 4.29%, from 4.16% last week and compared with expectations of a 4.20% rate.
The auction also saw the highest ever spread over the minimum bid rate at one of its weekly auctions. The marginal rate, or lowest successful bid, was 4.27% compared to the ECB's 4% benchmark interest rate, chalking up another record spread indicating exceptionally strong demand.
Banks' reluctance to lend was shown by the continued high level of three-month euro Libor, fixed at an elevated 4.72625% against 4.72938% on Monday but still well above the ECB's 4% target rate.
The ECB has intervened heavily in the interbank market since Aug. 9, as spillover from the U.S. subprime mortgage crisis has caused a global credit squeeze with many banks very unwilling to lend to each other.
Sterling Market Calmer
Tension continued to fade in the UK money markets as the Bank of England's efforts to bring down three-month lending rates continued to take effect.
Three-month sterling deposits fixed lower on Tuesday for the tenth straight session at 6.34375% against 6.355% on Monday and its lowest since August 10.
But both sterling and euro three-month rates continue to show a premium of more than half a percentage point over BoE and ECB base rates reflecting high demand for funds.
There was more reassurance on the outlook for the most serious UK casualty of the credit crisis -- mortgage lender Northern Rock, which has been engulfed in crisis since the Bank of England stepped in to offer emergency funding on Sept. 14 as the "lender of last resort."
A source close to the UK Treasury said Britain's government had appointed U.S. investment bank Goldman Sachs , as adviser on the guarantee safeguarding existing deposits at the stricken bank, which was the first major British bank to suffer a run on deposits for more than 140 years.
Matt Ridley, Northern Rock's chairman, meanwhile said in a letter sent to MPs late on Monday that the bank remained "profitable and sound, with assets well in excess of liabilities."
The credit problems have taken their toll on German business sentiment with a fall in the influential Ifo business climate index to 104.2 in September from 105.8 in August, below the 105.0 expected by economists.
"The turbulences on financial markets have had an impact," Ifo institute chief economist Gernot Nerb said on Bloomberg Television. "We are seeing a weakening in the upswing, but not an end to it."
Analysts were more optimistic about the state of investor demand in the bond market as U.S. investment bank Morgan Stanley announced plans to sell a 10-year euro bond and said orders had topped 1 billion euros.
French electrical engineering firm Schneider Electric was also setting a test for investor risk appetite on Tuesday as it brought the first triple-B rated euro corporate bond deal in months to the European market.
"It's generally a good sign," said Nick Hayes, a fund manager at New Star Asset Management. "It suggests there is cash and confidence in the market and that people are prepared to invest in these deals."