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Demand for dollar spikes outside US as debt deadline looms

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Demand for dollar cash outside the United States surged on Tuesday, with market participants paying sharply higher premiums to get their hands on dollars to tide them over a mid-October deadline to raise the U.S. borrowing limit.

Banks and investors around the world always have a need for dollar liquidity, but do not have direct access to the lending windows run by the Federal Reserve which guarantee U.S. banks easy access to cash.

As a result, they typically pay a premium to raise dollars via the foreign exchange forward markets. As worries over a potential liquidity crunch in the coming weeks have risen, so have those market rates.

The spike in rates came a day before the European Central Bank's weekly dollar auction for euro zone banks.

The benchmark three-month euro/dollar basis swap rate fell to a three-week low on Tuesday, with equivalent dollar/yen rate at its lowest this year.

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That means the premium euro zone banks and investors are paying to access dollars in the foreign exchange forward market was the highest for three weeks, and the equivalent premium for dollars over yen the highest this year.

The premium for two-week dollar funds over euros rose to its highest since March, and the premium over sterling to its highest this year, as market participants looked nervously towards the October 17 deadline.

The rise in these premia doesn't reflect strains in European or Japanese banks themselves as much as a growing need for dollar liquidity over a potential "funding hump'' on the horizon.

"We're seeing a reasonably sharp move this morning - nothing to get too scared about, but we are definitely starting to see some strains now,'' said Chris Clark, rates strategist at broker-dealer ICAP in London.

"This isn't reflecting a change in risk outlook, or a major fundamental risk to the economy or financial system, but a liquidity crunch based around one particular day.''

FX: Market is starting to buy short USD positions

Unless Congress reaches agreement to raise the debt ceiling, the United States will hit its borrowing limit of $16.7 trillion on or around October 17.

The government will probably have cash to pay its bills for another two weeks, but could then take the unprecedented step of defaulting on some obligations around the turn of the month.

Investors are increasingly preparing for that possibility.

The difference between lending euros for dollars in the FX forward market - the two-week euro/dollar basis swap rate - fell to -21 basis points, the highest premium demanded for dollars over euros since March.

(Related video: Debt drama weighing on the dollar; gold demand strong)

The two-week sterling/dollar basis swap rate fell to -18 basis points, the lowest this year, according to ICAP data.

The three-month euro/dollar rate fell to -8 basis points, the lowest in three weeks.

Data from Japanese broker Meitan Tradition showed the three-month dollar/yen basis rate at -18.125 basis points, the lowest since December.

Non-U.S. banks and their clients usually fund their dollar assets via short-term money markets. But ahead of a quarter- or year-end, or in times of increasing market tension, natural lenders of dollars like U.S. banks and money market funds constrict their lending.

(Read more: Emerging markets may become new force in euro rally)

This forces the interbank and repo market to turn to other sources of funding, such as the FX forward market.

Euro zone banks do have one easy option to get hold of dollars. The ECB will hold not only its usual weekly offering of seven-day dollar funding on Wednesday but also one where banks can borrow for almost three months.

This swap line with the Federal Reserve was set up in the immediate aftermath of Lehman Brothers' collapse in 2008 and extended last year. Euro zone banks have drawn down virtually nothing at all over the last six months.

—By Reuters.