By Kirsten Donovan
LONDON, June 3 (Reuters) - If a new Greek aid deal is
secured, as seems likely, the euro zone interest rate swap curve
could return to its flattest levels versus the UK curve as the
way is cleared for the ECB to normalise monetary policy.
Increasing prospects of an interim deal for Greece have
supported bets the European Central Bank will raise rates in
July. Market pricing had shown investors trimmed expectations of
a hike as the euro zone crisis escalated in the last three
weeks.
The relative moves of the sterling curve versus that of
euro rates are known as a "box" and market players trade by
placing a flattening position on one curve versus a steepening
position on the other.
The UK/euro 2-10 year interest rate swap box hit euro
lifetime highs near 100 basis points in mid-May, according to
Reuters data, before dipping to around 86 basis points earlier
this week as the euro zone yield curve steepened on doubts over
whether the ECB could continue hiking rates.
"We've gone through a very pessimistic stage because of the
Greek spread widening but if we can get an aid package together
... clearly we are going to see rate hikes priced back into the
front end of the euro curve," said Credit Agricole rate
strategist David Keeble.
"I imagine we'll get back close to the high levels but
probably not go through them as you don't want to be pricing in
more than we were three months ago when the ECB indicated they'd
start hiking rates."
The UK/euro zone swap rate box was last at 92 bps as the
prospect of a Greek aid deal refocused market attention on next
week's ECB meeting where the bank is expected to signal a July
rate hike by using the term "strong vigilance".
"The ECB have been adamant that they're on the road to
normalisation, the economy looks fairly sound and there is
likely to be a Greek aid package, so the ECB is going only in
one direction," said Societe Generale economist James Nixon.
In contrast, economists polled by Reuters forecast the Bank
of England will wait until the fourth quarter to raise UK
interest rates from their record low 0.5 percent.
The latest UK economic data is mixed at best, pushing rate
hike expectations back. [ID:nL9E7F600J].
Market pricing based on overnight indexed swaps is even more
dovish, showing a rate hike is not anticipated until the first
quarter of 2012.
"The BoE will arguably be the slowest central bank to get on
the full normalisation path because of the fiscal tightening,"
SG's Nixon said.
"The only problem with trading that view in the short term
is that because of rising inflation expectations, the BoE may
have to put in a couple of rate hikes but looking longer-term it
will be raising once or twice and then getting stuck."
Commerzbank strategist Christoph Rieger said a bearish
flattening of the euro yield curve would occur if a new deal for
Greece is found, and if the ECB signal a July interest rate
hike, which the bank says is around 85 percent priced in.
The market was unlikely to fully price such a move just yet.
"Given the implementation risk in coming weeks, the Eonia
curve is unlikely to discount a 100 percent chance of a July
rate hike even if Trichet says 'vigilance' next Thursday.
"In the most adverse accident scenario, on the other hand, we
believe that the bullish steepening potential is limited at
Schatz yields around 1.60 percent."
Benchmark three-month euro Libor rates EUR3MFSR= were
steady at 1.38313 percent, while equivalent sterling rates
GBP3MFSR= were similarly little changed at 0.82625 percent.
