by Divyang Shah LONDON, June 2 (IFR) - We continue to hold the view that at the ECB meeting next week we will see 1) the utterance of "strong vigilance", thus confirming a hike at the July meeting and 2) another quarter in which the ECB will keep its operations with full allocation. The ECB's desire not to be seen as having softened its approach to achieving price stability and be held hostage to a political inability to effectively deal with the crisis is likely to mean the post-meeting Q&A will also be hawkish. We have chosen to play for a more hawkish ECB via 1) payer spread on 1y1y EUR 2) paying the 9x12 EONIA forward and, 3) put spreads on Schatz futures. While there are risks related to the peripheral debt crisis, the ECB feels its liquidity facilities are capable of handling any system-wide fallout related to the debt crisis. Remember the ECB was the first central bank to react appropriately (9 Aug, 2007) when money markets froze as a result of the sub-prime crisis. This is still the ECB's separation principle at work. On a Eurozone wide basis the growth surprises remain to the upside and inflation is elevated. On the latter, the ECB continues to focus on the fact that real interest rates are negative and the recent flash estimate (2.7% inflation in May down from 2.8% in April) will not impact the ECB's thinking. The ECB has set the stage for normalization of policy, and we continue to believe that the ECB will not stop hiking rates until it has reached 2.00% where a pause is likely. There are also internal reasons for maintaining the rate hike course in the form of a handover of the Presidency. ECB's Trichet does not want to be seen as having conducted another U-turn on his watch, while the likely successor BoI/ECB's Draghi will not want to give an early impression of being a dove. A changeover is usually accompanied by the markets questioning the hawkishness of the new leader. Having played the role of a firefighter during the sub-prime crisis, the post-Lehman environment and the sovereign debt crisis, the ECB wants to refocus on its primary mandate. While where official rates are is important from the perspective of how much the market lends and borrows from the ECB, it is the level of excess liquidity that determines where the more important money market rates trade. The spread between EONIA and the refi rate has persisted despite the 25bps April hike. More recently the market has priced out the spread returning to a more normal setting, and instead priced in the likelihood of this spread persisting beyond Q3 and into early 2012. This has been an effective loosening of monetary policy, and the ECB hiking by 25bps in July will look to take back some this.

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