FRANKFURT: Key euro-priced bank-to-bank lending rates hit their highest levels in two years on Wednesday as excess liquidity in the banking system fell to a two-year low, but any further rise in rates might be capped by the European Central Bank's generous liquidity policies.
Traders said short-term market rates could plateau as the price of money in the markets is approaching that of central bank funds, and liquidity is likely to rise this week.
Excess liquidity in the money market has dwindled in recent months and is currently around 4 billion euros, the lowest since May 2009, according to Reuters calculations.
On Tuesday, banks asked for 118 billion euros in weekly funds from the ECB, money that will be handed out today and increase excess liquidity in the system to around 30 billion euros, reducing pressure on rates.
In a three-month tender on Wednesday, banks took 63 billion euros in funds, below the average expectation of 75 billion in a Reuters poll and the 71 billion in expiring funds.
The ECB has offered unlimited funds at its main refinancing operations at a fixed interest rate since October 2008 and currently offers banks all the money they want in all its liquidity operations.
But with lack of clarity on the bank's future rate path, some investors may hang on to their money.
"In this situation some people may hold on to their money to see where the market is going," a euro zone money market trader said.
"I don't see any reason for panic, there is enough money to keep rates where they are now ... If rates go up too high, there is going to be huge demand at the MRO.
The interest rate at that main refinancing operation will be 1.25 percent -- very close to the 1-week Euribor rate of 1.214 percent.
Expectations of policy tightening and a bank-led reduction in excess money market liquidity have been the main drivers behind a 35 basis point rise in bank-to-bank lending rates since the start of the year.
The three-month Euribor rate -- traditionally the main gauge of unsecured interbank euro lending and a mix of interest rate expectations and banks' appetite for lending -- rose to 1.365 percent on Wednesday, the highest since late April 2009 and up from 1.361 percent the previous day.
EONIA overnight interest rates fell to 1.297 percent on Tuesday, still above the ECB's main policy rate.
The bank raised euro zone rates by a quarter of a percentage point to 1.25 percent earlier this month, ending almost two years of record-low borrowing costs.
ECB Executive Board member Jose Manuel Gonzalez-Paramo said on Tuesday euro zone interest rates are unusually accommodative and people should expect cheap money to come to an end. Another policymaker, Cyprus' Athanasios Orphanides said on Wednesday the ECB may act if the inflation picture worsens.
Two-thirds of the 62 economists polled by Reuters after the rate hike, which until last month would have shocked experts, expect another rise by July at the latest.
Attention is also focusing on what the central bank will do with its unlimited liquidity policy in the coming months.
In March it left all its operations at full allotment until July, putting its exit strategy on hold for the second quarter running. But recent comments from policymakers Ewald Nowotny and Axel Weber have increased expectations that the bank will soon restart the phasing-out process.
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