RTRS: Further ECB hikes seen unlikely this yr as crisis deepens
By William James
LONDON, July 12 (Reuters) - Markets cut expectations that the European Central Bank would raise interest rates again this year as the euro zone debt crisis spread to Italy, the region's third largest economy.
Pricing of the overnight rate curve -- used as a proxy for central bank rates -- showed euro zone interest rates were now more likely to remain unchanged into year-end than to rise.
Less than a week ago the central bank raised rates to 1.5 percent and showed no sign of backing away from its intention to keep hiking to control inflation stemming from core European countries. Last Friday, markets were pricing in a good chance of a third rate hike.
Those expectations have been cut sharply in light of the rapid deterioration of confidence in Italian sovereign debt and, with no end to bond market stress in sight, were unlikely to rebound any time soon, analysts said.
"We're pricing out ECB hikes to a large extent. The Eonia forwards curve is basically flat, with no hike priced in," said Commerzbank rate strategist Benjamin Schroeder.
"The ECB is still on course (to hike rates) judging by its previous statements so I would expect a steeper curve... but that return to a steeper curve might come rather slowly."
Eonia rates linked to year-end were only 11bps higher than the implied rate for the ECB's August meeting -- indicating less than a 50 percent chance of another hike this year.
Euribor futures <0#FEI:> rallied across the 2011/12 strip, implying markets were expecting the upward pressure on interbank borrowing costs from interest rates to wane. Euribor and euro libor three-month interbank rates both fixed lower.
The December Euribor futures contract rallied by as much as 12 ticks before receding in line with volatile government bond market moves.
COUNTERPARTY CONFIDENCE FALTERS
Signs that the crisis, which has so far claimed Greece, Portugal and Ireland, could take down one of the region's largest economies also heightened tension in interbank markets, driving measures of counterparty risk higher.
The spread between Libor rates and overnight index swaps, which roughly equates to the risk premium added by lenders in the unsecured interbank market, spiked by 9 bps to 26 bps, its highest since early January.
"We've seen quite a big move in the spread in the last couple of days as a function of the fact that banks are a lot more wary and putting a bigger premium on unsecured lending," said Simon Shaw, chief economist at FXPro.
Dollar funding costs for euro zone banks also pushed higher. The one-year euro/dollar currency basis swap spread , which expands when dollars become more expensive, widened to 39 basis points, around 6 bps more than on Friday.
Tension was also evident at the ECB's regular offering of banking sector funding, with more banks bidding and a greater overall amount of money borrowed.
Banks took 154 billion euros in the ECB's weekly 7-day refinancing operation, well above the 134 billion traders had expected and the 120 billion they took last week .
Participation was also high with 230 banks taking funding compared to 185 last week, although it was within the range of recent months.
"I think you can see the crisis to a limited degree here. I think there has been more cautious bidding here, but nothing that would indicate panic bidding," Commerzbank's Schroeder said. (Additional reporting by Marc Jones in Frankfurt)
