LONDON: A barometer of dollar funding risk traded near its best levels since mid-2011 on Monday, as subsiding fears about the euro zone debt crisis are improving the region's banks' access to dollars. Investors have been piling into high-yielding Italian and Spanish government debt this year, encouraged by the safety net provided by the European Central Bank's bond-buying programme (OMT) and improving economic data out of the United States. That brought borrowing costs in the two countries down to affordable levels and through the tight link between banks and sovereigns seen during the three-year-old crisis improved funding conditions for euro zone banks as well. The three-month euro-dollar cross currency basis swap , which shows the rate charged when swapping euro interest rate payments on an underlying asset into dollars, was last minus 17.5 basis points, unchanged from the close on Friday when it hit its narrowest in about 20 months at -17 bps. The measure, which widens in times of stress when dollars are harder to find, traded as wide as minus 25 bps at the end of last year and minus 167.50 in November 2011 at the height of a previous wave in the euro zone crisis before massive three-year ECB cash injections cooled the situation. Subsequent moves by euro zone banks to reduce their dollar funding needs last year have also contributed to the narrowing in cross currency spreads, analysts said. "The need for dollars has decreased as (banks) have shrunk their dollar loan books, and the improvement in the European financial situation has helped as well. European banks are seen as a better credit than a year ago," said Chris Turner, head of FX strategy at ING. David Keeble, global head of fixed income strategy at Credit Agricole, said the narrowing in spreads is part of a "healing process" for the European banking system, which is not yet over. He said levels in the negative low single digits would signal "normal" dollar funding conditions. REPAYMENT Whether FX swaps could reach such levels near-term depends on the pace at which banks will repay the nearly 1 trillion euros in three-year loans taken from the ECB in December 2011 and February 2012. The ECB said on Friday that 137 billion euros would be repaid early. That amount exceeded expectations and was taken as a sign that areas of the banking system were recovering. But that perception could change quickly if banks replace the long-term funds with shorter-term borrowing at the ECB's weekly liquidity operations. The ECB holds one-week and three-month unlimited lending tenders on Tuesday and Wednesday, respectively. "We've tightened a lot but I'd say we're going to struggle to tighten further. Some caution is warranted, we need to see whether more loans will be taken on a shorter-term basis," said FXPro chief economist Simon Smith. Smith added that the tightening was driven mainly by sentiment and not by fundamental economic data, which makes the trend vulnerable to a sharp reversal. "Were there to be a Spanish downgrade or another ripple in the European financial story, it (the three-month euro-dollar FX swap) could widen to about (minus) 50 bps," ING's Turner said.

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